Some Results on Bond Yield and Default Probability

Abstract

Fisher [5] suggested that the difference between a corporate bond's promised yield-tomaturity (YTM) and the YTM of a government bond of the same maturity is composed of the sum of the corporate default risk, the variability of the firm's earnings, the firm's reliability in meeting its obligations, its capital structure, and the bond's marketability. Since then, Fisher's measure has often been used to measure bond risk. For example, Fraser and McCormack [6] have used the spreads between newly issued bank bonds and Aaa bonds of compatible maturities (as substitutes for riskless government bonds) to measure the changes in banks' borrowing risk after two large bank failures. In their paper, spread is intended to provide for intra-firm (industry) default risk comparisons over time. Radcliffe [15] uses yield spreads to differentiate the riskiness among corporate bonds. In this case, the spread is used for inter-firm risk comparisons. Sharpe [18] has suggested a similar measure of bond default risk which is the YTM less the expected rate of return. However, most of these papers do not provide a bond pricing model which would furnish the link between a firm's riskiness and the YTM and default risk of its bond. Without this, it is difficult to draw inferences between YTM's and default risk.