How to Determine Risk Premium on Bonds

Putting your money into bonds carries risk, just like investing in most other securities. If one bond carries more risk than another, buyers want a higher return on their money to make the higher-risk bond a worthwhile investment. When you compare different bonds or types of bonds, a risk premium is the additional return the riskier bond pays.

Nature of Risk

Bonds pay fixed amounts of interest, and investors typically buy them to get this interest income, but there are several kinds of risk associated with bond investing. For example, default risk is the chance the bond issuer won’t be able pay off a bond when it matures. Some bonds have features that carry extra risk. Trading volume on some bonds is low, meaning it might be difficult to sell it quickly. Duration is another factor. Bonds with long maturities have greater risk. Collectively, the various risks are often called the credit spread. If you are going to invest in a bond that carries a lot of risk, you’ll naturally want it to earn a higher interest rate to offset the extra risk. The increase in the yield, or interest rate, is the risk premium of the bond.

Yardstick for Bond Risk

To determine the risk premium on bonds, you need a benchmark. United States Treasury bonds serve this purpose well because they carry virtually no credit risk. Typically, yields are higher on corporate bonds that have default and other risk factors. Corporate bond yields usually are compared to the yield on 10-year Treasury bonds. Alternatively, you might want to compare the relative risk of similar bonds. For example, you could check a high-yield corporate bond yield against the FINRA/Bloomberg index of high-yield bond issues.

Determining Credit Spread

To find the credit spread, subtract the 10-year Treasury yield from the corporate bond yield. Suppose 10-year Treasuries have a yield of 2.5 percent. If a corporate bond has a yield of 6 percent, the credit spread is equal to 3.5 percent. You don’t have to use 10-year Treasury bonds as your yardstick. If you are evaluating a corporate bond with a five-year maturity, you might want to measure its yield against five-year Treasuries instead.

Inflation Risk

Over time, inflation can eat away at the value of the money you invest in bonds. Normal U.S. Treasuries are subject to this inflation risk. Treasury Inflation Protected Securities, called TIPS, are not subject to the same risk because their value is adjusted for inflation. You can estimate the expected inflation by subtracting the yield of a TIPS bond from that of regular Treasury bonds. For instance, if the 10-year Treasury yield is 2.5 percent and a TIPS bond is paying 1.5 percent, the inflation risk factor is 1 percent. Add this allowance for expected inflation to the credit spread to determine the overall risk premium on a bond.

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