Original-issue systematic and default risk pricing efficiency of speculative-grade bonds

Abstract

We investigate whether primary market, original-issue risk premiums on speculative-grade debt are justified solely by expected defaults or whether these risk premiums also include other orthogonal risk components. Studies of secondary-market holding period risk and return have hypothesized that risk premiums on speculative-grade debt may be explained by bond-and equity-related systematic risk and possibly other types of risk. Using an actuarial approach that considers contemporaneous correlation between default frequency and severity and first-order serial correlation, we cannot reject the hypothesis that the entire original-issue risk premium can be explained by expected default losses. This suggests that speculative-grade bond primary markets efficiently price default risk and that other types of risk are priced as coincident as opposed to orthogonal risks. ©The Journal of Risk and Insurance.

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Journal of Risk and Insurance

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