Risk premia on a corporate bond can be broken down into two component parts. The first is the term premium, which relates to the risk premium on an underlying government bond, and is the extra yield that investors require on longer-dated bonds to compensate them for the risk of unexpected moves in inflation or the wider economy, or uncertainty regarding central bank policy (see a previous blog comment here for more). The second, which relates to corporate bonds, is the credit spread, which is the extra yield that investors require to compensate them for risk of default and illiquidity. Adding these together provides a measure of overall risk premium.
The blue line in the chart below plots this total risk premium on 10-year US corporate bonds, where we have taken the ACM Model on a 10-year US Treasury to determine the term premium, and added the credit spread on a US 7-10 year BBB rated corporate bond index. Incidentally, the correlation between these two measures of risk premia has averaged +0.69 over the last two decades.
The purple line plots the total return from the corporate bond index 1 year forwards. Risk premia have been a reasonable predictor of future returns, and the current record low levels of premia on corporate bonds should therefore serve as a warning.
