Corporate Risk Premium

Diego Mendez-Carbajo, Department of Economics, Illinois Wesleyan University

This material was originally created for Starting Point: Teaching Economics
and is replicated here as part of the SERC Pedagogic Service.

Summary

This case quantifies how financial markets assign different default risk premiums to corporate bonds over time. This activity can be used as either (a) an instructor-led example in which the instructor shows –either on paper or a screen– the data and students analyze them, or (b) as a student exploration in which students find the specified data. Instructors with less time could use option (a) and instructors interested in their students learning about the FRED database could use option (b).

This activity plots the yields of a high-yield corporate bond (e.g. Moody's Baa Corporate Bond Yield) and a low-yield corporate bond (e.g. Moody's Aaa Corporate Bond Yield) and computes the difference between the two of them. This difference is an approximation of the corporate bond default risk premium and it displays both a secular trend and cyclical behavior.

This activity is suitable for addressing each of the following issues:

1. Why does the corporate bond risk premium increase or decrease over time?

2. How did the corporate bond risk premium adjust after the 2008-2009 financial crisis?

3. What is the role of rating agencies in helping financial markets assess corporate bond default risk?

Learning Goals

After the completion of this module students will be able to:
1. Use FRED graphs to perform data manipulations.
2. Use FRED graphs to perform a visual data comparison
3. Assess how the corporate bond risk premium changes in value during expansions and contractions.
4. Understand the difference between the short-run and the long-run.

Context for Use

Ideally, this module should be directed to a financial economics class. It can be used as either (a) an instructor-led example in a large lecture or (b) student groups can be assigned to replicate it outside of class as a basis for a short assignment. Between the presentation of the data and the ensuing discussion, instructors should allocate 20-30 minutes of classroom time. The discussion could focus on the factors that drive the assessment of corporate bond default risk and how their evaluation changes with the phase of the business cycle.

Note that a more advanced treatment of this topic may compute the corporate bond risk premium between different classes of corporate bonds or against the risk-free interest rate (e.g. 3-Month Treasury Bills). These exercises may be used to illustrate how the choices made regarding data can either support or undermine a theoretical construct.

Prerequisite skills: Graph literacy
Prerequisite concepts: Risk and return; Rating agencies; Corporate bond risk premium

Description and Teaching Materials

The following is a description of this activity being used as an instructor-led example. For a basic step-by-step description of this activity –also suitable for a student-led exploration of the topic– please see the Handout Activity Handout for Corporate Risk Premium (Microsoft Word 26kB Jun27 14).

Within a lecture discussing risk-free and risky interest rates, an instructor will use this module to help students understand the concept of risk premium and to guide a discussion of its quantification.

(Step 1)
The instructor will first present a graph of Moody's Seasoned Baa Corporate Bond Yield (BAA) (Category: Money, Banking & Finance > Interest Rates > Corporate Bonds > Moody's)

The instructor should point out that since the 1980s the trend value of the Baa corporate bond yield has been declining in trend, frequently increasing during recessions. Narrowing the range of the data set to 1990-present will make that pattern more obvious. This fact will become relevant when introducing an additional data series.

The instructor can ask students to identify periods when the series is increasing or decreasing in order to review the relationship between bond yield and bond price. Questions of volatility can also be brought up by pointing out sudden and large changes in the value of the series.

(Step 2)
The instructor will then "Add a Data Series > Add New Series", graphing Moody's Seasoned Aaa Corporate Bond Yield (AAA) (Category: Money, Banking & Finance > Interest Rates > Corporate Bonds > Moody's)

The instructor should point out that there is frequent co-movement between the series but that the yield of Aaa corporate bonds never exceeds the yield of Baa corporate bonds. The instructor can ask students to put forward an argument for why that is the case.

(Step 3)
The instructor will then "Edit Data Series 2" (Moody's Seasoned Aaa Corporate Bond Yield (AAA)) by deleting it [click on trash can icon to the right of the series' name].

Next, the instructor will "Add a Data Series > Modify Existing Series > Data Series 1", graphing Moody's Seasoned Aaa Corporate Bond Yield (AAA) (Category: Money, Banking & Finance > Interest Rates > Corporate Bonds > Moody's)
These steps are needed in order to have both series as part of the same database object and allow for their manipulation. This manipulation is accomplished by selecting "Create Your Own Data Transformation > Formula > a – b > Apply"

The graph now plots the difference between Baa and Aaa Moody's Seasoned Corporate Bond Yields, a computation of the risk premium between two different classes of financial assets.

The following is a list of questions that could be asked:
- How does the corporate risk premium change in value during economic expansions and contractions? Why??
- What would you say was remarkable about the evolution of the corporate risk premium before, during, and after the 2008-2009 recession?

Further sophistication:
- Plot the difference between the Aaa Corporate Bond (AAA) and a "risk-free asset" (e.g. the 3-Month Treasury Bill: Secondary Market Rate (TB3MS)
- Plot the corporate risk premium (BAA-AAA) against the CBOE Volatility Index VIX (VIXCLS). How effective is the VIX index in capturing corporate risk?
- Plot the CBOE NASDAQ 100 Volatility Index (VXNCLS) against the CBOE Volatility Index VIX (VIXCLS). What set of assets is riskier? How would you expect that risk difference to behave?

Teaching Notes and Tips

The Federal Reserve Bank of San Francisco's Economic Letter "The Price of Stock and Bond Risk in Recoveries" (see full reference under Resources) discusses the evolution of risk premiums across asset classes during different business cycles, comparing it with the 2008-2009 recession. This is a great resource to carry the discussion further.

The popular press abounds in assessments of corporate and sovereign risk. These can be used to provide more poignant context. An example is "Record Company Bond Sales Looming as Costs Drop: Turkey Credit" (see full reference under Resources).

Assessment

The recommended method for assessment for a financial economics class would be to have students write up a short memo where they discuss the historical evolution of corporate bond risk premiums computed as the difference between high-yield and low-yield corporate bonds. This should be a take-home assignment.

References and Resources

"The Price of Stock and Bond Risk in Recoveries" by Simon Kwan
Federal Reserve Bank of San Francisco Economic Letter 2013-23, August 19, 2013
http://www.frbsf.org/economic-research/publications/economic-letter/2013/august/stock-price-bond-risk-economic-recovery/

"Record Company Bond Sales Looming as Costs Drop: Turkey Credit" by Ercan Ersoy
Bloomberg News L.P. (Bloomberg.com), December 31, 2012
http://www.bloomberg.com/news/2012-12-31/record-company-bond-sales-looming-as-costs-drop-turkey-credit.html

"Volatility Indexes at CBOE" by CBOE
Chicago Board Options Exchange (CBOE.com), January, 2012
https://www.cboe.com/micro/VIX/pdf/VolatilityIndexQRG2012-01-30.pdf