DEFAULT SPREADS ON BONDS

The interest rates on bonds are determined by the default risk that investors perceive in the issuer of the bonds. This default risk is often measured with a bond rating, and the interest rate that corresponds to the rating is estimated by adding a default spread to the riskless rate. In Chapter 4, we examined the process used by rating agencies to rate firms. This chapter considers how to estimate default spreads for a given ratings class and why these spreads may change over time.

Estimating Default Spreads

The simplest way to estimate default spreads for each ratings class is to find a sampling of bonds within that ratings class and obtain the current market interest rate on these bonds. Why do we need a sampling rather than just one bond? A bond can be misrated or mispriced. Using a sample reduces or eliminates this problem. In obtaining this sample, you should try to focus on the most liquid bonds with as few special features attached to them as possible. Corporate bonds are often illiquid and the interest rates on such bonds may not reflect current market rates. The presence of special features on bonds such as convertibility can affect the pricing of these bonds and consequently the interest rates estimated on them.