David and Goliath: On the US Investment Grade Credit Risk Premium

Abstract

We analyze the US Corporate Investment Grade (IG) credit risk premium, as represented by the average excess return of US corporate IG bonds over duration-matched US Treasuries. Over the period January 1973 through April 2018, this credit excess return averaged 60 bps p.a. (implying a stand-alone Information Ratio of 0.16), which is deemed unattractively low. Breaking with standard practice to analyze this credit excess return in isolation, we instead propose a portfolio perspective that does justice to corporate bonds as “package deals”, offering exposure to both interest rate risk and credit risk. Because of diversification effects within this portfolio, not the stand-alone credit risk exposure is relevant but its contribution to total bond risk. As a result, the total risk premium on corporate bonds is a composite risk premium, composed of a pure asset risk premium (the term premium stemming from the “Treasury part”) and a factor risk premium which can only be earned in tandem with the term premium (reflecting the diversified credit risk contribution). Accepting the term premium as fair, we can use the relative risk contributions to solve for the implied credit risk premium. From a macro view, this implied credit risk premium is the fair premium that investors would require as compensation for bearing the credit risk exposure contained in the aggregate market value of outstanding US IG bonds. We find that the implied credit risk premium was 44 bps, which is well below the historical average credit excess return of 60 bps. From our package deal perspective, the historical credit risk premium is not small at all.