Is Default Event Risk Priced in Corporate Bonds?

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Abstract
We provide an empirical decomposition of the default, liquidity, and tax factors that determine credit spreads and expected corporate bond returns. In particular, we estimate the risk premium associated with a default event. We model default as a jump process with stochastic intensity. The default intensities are a function of common and firm-specific factors. In the model, excess corporate bond returns can be due to risk premia on factors driving the intensities and due to a risk premium on the default jump risk, besides tax and liquidity effects. The model is estimated using data on corporate bond prices for 104 US firms and historical default rates. We find significant risk premia on the common factors that drive intensities, as well as important tax and liquidity effects. These components go a long way towards explaining the level of credit spreads and expected corporate bond returns. Adding a positive default event risk premium helps to explain the remaining error, although this premium cannot be estimated with high statistical precision.

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