Modeling Expected Return on Defaultable Bonds

Abstract

The existing literature on credit risk focuses on fitting bond prices and explaining yield spreads, while largely skirting the issue of expected return. The unique feature of credit risk, however, implies that the expected return on defaultable bonds is not synonymous with the (pre-default) price process as in the case of default-free bonds. In this paper, the expected return on defaultable bonds is examined within the framework of intensity-based credit risk models. It is shown that a defaultable bond's instantaneous expected return can be decomposed into three parts: a default-free component, a compensation for variations in default risk, and a compensation for investors' risk-aversion towards the default event. The methodology for estimating these components as well as the practical difficulties one might encounter in this estimation are discussed. Easily extended to include a non-default component, this decomposition can enrich our understanding of many empirical observations concerning credit risk.