Explaining the Rate Spread on Corporate Bonds

Abstract

The purpose of this article is to explain the spread between spot rates on corporate and government bonds. We find that the spread can be explained in terms of three elements: (1) compensation for expected default of corporate bonds (2) compensation for state taxes since holders of corporate bonds pay state taxes while holders of government bonds do not, and (3) compensation for the additional systematic risk in corporate bond returns relative to government bond returns. The systematic nature of corporate bond return is shown by relating that part of the spread which is not due to expected default or taxes to a set of variables which have been shown to effect risk premiums in stock markets Empirical estimates of the size of each of these three components are provided in the paper. We stress the tax effects because it has been ignored in all previous studies of corporate bonds.