Michael Dueker

English

Research Papers in Economics

November 1998
MonetaryTrends
Risk Premiums among
Corporate Bonds
To help insure against lower-than-expected returns,
investors in speculative projects generally insist on com-
mensurate risk premiums in required yields.  In early
1997, prior to the financial crisis in Asia, the Federal
Reserve noted that ￿risk premiums for advancing funds
to businesses in virtually all financial markets had
declined to near-record lows￿ (1997 Monetary Policy
Objectives, p. 8).  Federal Reserve reports questioned
whether investors, emboldened by high current profits
and incomes, were adequately accounting for the risks
associated with marginal investment projects and capital
goods that might not yield their expected returns in the
future.  Low risk premiums on business obligations in
early 1997 may have been ￿based on a perceived
environment of persisting low inflation and balanced
economic growth that would lower the odds of dis-
ruptions to economic activity￿ (Report to Congress,
Feb. 26, 1997, p. 20).
In the U.S. economy, one of the most visible risk
premiums is the difference in yields between corporate
bonds that belong to different risk categories, depending
on the strength of the issuing company.  Aaa ratings are
for high-grade bonds and Baa ratings are for medium-
grade bonds.  (So-called junk bonds are corporate bonds
not considered to be of investment grade.)  The risk
premium in the yield required of Baa corporate bonds
above the yield on Aaa corporate bonds has averaged
about 1.15 percentage points since 1970.  Since 1984,
the risk premium has averaged somewhat less at 0.95
percentage point, perhaps because the U.S. economy has
had comparatively fewer recessions since 1984 than
between 1970 and 1983.  Since the beginning of 1994,
the risk premium has averaged only 0.64 percentage
points.  Following Russia’s default on sovereign debt in
mid-August 1998, however, the risk premium on Baa
corporate bonds has risen by about 20 basis points to
roughly 0.8 percentage points, as the accompanying
chart of daily data through Oct. 7, 1998, shows.  
Both Aaa and Baa corporate bond yields have fallen
since August 1998, but investor preferences have shifted
in favor of Aaa bonds, mirroring the flight to quality that
has caused U.S. Treasury bond yields to fall by an even
larger amount.  The wave of financial crises in numerous
emerging markets overseas has apparently heightened
concern among bond market participants that turmoil in
emerging markets could disrupt economic activity in the
United States through the loss of export markets and cap-
ital losses on investments in those countries.  To date,
however, the risk premium on Baa bonds is still below its
average level since 1984.  Thus, while financial problems
in emerging markets have reminded investors that the
U.S. economy is still bound to experience negative
shocks, investors do not seem to believe that American
corporations face any unusual threat to their survival.
￿Michael Dueker
Views expressed do not necessarily reflect official positions of the Federal Reserve System.
1994 1995 1996 1997 1998
0.4
0.5
0.6
0.7
0.8
0.9
Percent
Baa Yield Less Aaa Yield

Risk premiums among corporate bonds

http://research.stlouisfed.org/publications/mt/19981101/cover.pdf

Risk premiums among corporate bonds

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Research Papers in Economics