Cost of Debt vs. Expected Return of Debt
Can somebody please explain to me how I can determine the "expected return on debt" from the promised yield on an outstanding corporate bond?
I understand that if there is some chance of default, the expected return on a bond will be lower than the current YTM on the outstanding bond, especially for junk bonds.
However, I always thought that an increase in default risk will be reflected in a lower market price and thus generate a higher YTM to compensate for the higher default premium.
If I am supposed to back out the default premium, won't I just be left with the risk-free rate?
Hope you guys can help shed some light on this.
Thanks
There are more risks than default ie. sovergeign, political, business, financial, liquidity, interest rate, embedded options. I would suggest you brush up on OAS - Option adjusted spread, Z spread, and nominal spread. This should clear up some of your answers.
But don't all those risks basically imply how likely or not likely the borrower is to repay his debt to the lender (i.e. imply default risk)?
bump
Sorry for bumping this post again, but could someone please help explain the difference between the promised cost of debt (YTM on outstanding bonds) and the expected cost of debt (taking in the probability of default) and how I can go about calculating the later?
Thank you
I think you're confusing default risk premiums with general risk premiums. The risk premium on a bond is more than just the expected loss*probability of default, investors are risk averse and dont like to bear the default risk (and they want disproportionately more premia as probability of loss increases) so they charge more than just what's needed to cover the loss.
YTM on outstanding bonds takes into account a risk premium as well as a probability of default whereas "expected return on debt" is a risk neutral measure... So expected return on debt = risk free + (YTMp(nodefault)+recoveryratep(default)) If the YTM was equal to that, it would assume that investors were indifferent between a bond with 50% default probability and a bond with 1% default probability as long as the expected return was the same, but this is not the case as investors are risk averse.
Hope that clears it up, not that its very clear itself.
and as for calculating the expected returns, you need some idea of default rates. you can't really back them out of bond prices because you want risk neutral default rates.
use historical data etc.
Thanks a lot. That does help clear it a bit.
But so what is the difference between the default risk premium and the general risk premium?
I always assumed that the only relevant risk premium for bonds was the default risk premium.
Also, what do you mean that they are "risk neutral" measures?
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