Modeling Expected Return on Defaultable Bonds

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Abstract
The 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. The author examines the expected return on defaultable bonds using 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 toward the default event. The methodology for estimating these components and 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.