Where Has My Credit Premium Gone?
In our view, the primary concern of corporate bond investors is estimating the expected excess return above Treasuries in order to justify additional risk. The option-adjusted spread of corporate bonds over Treasuries is frequently used to measure this expected excess return. We believe that the Credit Risk Premium (CRP) is a better measure.
Essentially, bond spreads have two components. One is the expected loss from default and downgrade. The second is an “extra” premium for illiquidity and all other risks, commonly referred to as the CRP. Our historical analysis of the CRP suggests a strong correlation with excess returns and much of the cross-sectional variation in credit spreads can be attributable to the CRP. Further, our research indicates that the CRP can provide valuable insight into expected credit returns. We believe the ability to forecast the CRP should be of great interest to credit investors.