Bond Risk Premium?

August 31, 2016

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StJL - “Bonds / Naybob – Is there a way to calculate the potential rates on bonds given the default rate and inflation? I guess Fed rates also enter in the equation and also leverage. But any rule of thumb!“

Again, the Fed funds rate is pure BS and meaningless. Its a visual, sitting in front of the TV set watching a channel with a snow signal on it, only a fool pays attention to a bad signal with that much static and noise. But some men, you just can’t reach…

When a bond is purchased, debt is created and money is lent based on and subject to the influences of three things: perceived risk of entity default; state and local taxes, which corporates are subject to and government issuance’s are not; and perceived systemic risk.

Regarding your question, a “risk free” premium (price) or rate can be observed with the 90 day UST bill. If you want to factor in inflation at the advertised “joke on the public” BS rate, use a TIPS rate or add that BS rate of inflation to the UST bill rate

To calculate the risk premium subtract the “risk free” rate or premium (price) calculated above from the rate or premium (price) on the bond you are considering purchasing. Be sure to subtract any other premiums specific to your subject bond viz. liquidity premium. The remainder is your risk premium or rate.

I know you speak of potential rates, which require either a crystal ball or utilizing current spreads of risk perception. Depending on your target bond, you can utilize certain spreads or indices of risk perception, viz. TED spread, LIBOR, Corp AAA, AA, A, BB, etc.

Remember as mentioned at the outset, there are three influences, so tax premium could be hiding in there. As expected default accounts for a surprisingly small fraction of the premium in corporate rates over treasuries, there could also be a very large spread for systemic risk.

viz. One premium analysis showed that on a particular 10 yr A rated corporate: 18% was for default (leverage considered), 36% for taxes, leaving 46% unexplained. Reading between the lines, probably 80-85% of that 46% was for systemic risk which is non diversifiable. Hope that helps. Out.