Explaining the Rate Spread on Corporate Bonds

The purpose of this article is to explain the spread between rates on corporate and government bonds. We show that expected default accounts for a surprisingly small fraction of the premium in corporate rates over treasuries. While state taxes explain a substantial portion of the difference, the remaining portion of the spread is closely related to the factors that we commonly accept as explaining risk premiums for common stocks. Both our time series and cross-sectional tests support the existence of a risk premium on corporate bonds. THE PURPOSE OF THIS ARTICLE is to examine and explain the differences in the rates offered on corporate bonds and those offered on government bonds ~spreads!, and, in particular, to examine whether there is a risk premium in corporate bond spreads and, if so, why it exists. Spreads in rates between corporate and government bonds differ across rating classes and should be positive for each rating class for the following reasons: 1. Expected default loss—some corporate bonds will default and investors require a higher promised payment to compensate for the expected loss from defaults. 2. Tax premium—interest payments on corporate bonds are taxed at the state level whereas interest payments on government bonds are not. 3. Risk premium—The return on corporate bonds is riskier than the return on government bonds, and investors should require a premium for the higher risk. As we will show, this occurs because a large part of the risk on corporate bonds is systematic rather than diversifiable. The only controversial part of the above analyses is the third point. Some authors in their analyses assume that the risk premium is zero in the corporate bond market.1 * Edwin J. Elton and Martin J. Gruber are Nomura Professors of Finance, Stern School of Business, New York University. Deepak Agrawal and Christopher Mann are Doctoral Students, Stern School of Business, New York University. We would like to thank the Editor, René Stulz, and the Associate Editor for helpful comments and suggestions. 1 Many authors assume a zero risk premium. Bodie, Kane, and Marcus ~1993! assume the spread is all default premium. See also Fons ~1994! and Cumby and Evans ~1995!. On the other hand, rating-based pricing models like Jarrow, Lando, and Turnbull ~1997! and Das-Tufano ~1996! assume that any risk premium impounded in corporate spreads is captured by adjusting transition probabilities. THE JOURNAL OF FINANCE • VOL. LVI, NO. 1 • FEBRUARY 2001