TAILIEUCHUNG - Explaining the Rate Spread on Corporate Bonds EDWIN J. ELTON, MARTIN J. GRUBER, DEEPAK AGRAWAL, and CHRISTOPHER MANN*

Stability Bonds would need to have high credit quality to be accepted by investors. Stability Bonds should be designed and issued such that investors consider them a very safe investment. Consequently, the acceptance and success of Stability Bonds would greatly benefit from the highest rating possible. An inferior rating could have a negative impact on its pricing (higher yield than otherwise) and on investors' willingness to absorb sufficiently large amounts of issuance. This would particularly be the case if Member States' national AAA issuance would continue and thereby co-exist and compete with Stability Bonds. High credit quality would also. | THE JOURNAL OF FINANCE VOL. LVI NO. 1 FEBRUARY 2001 Explaining the Rate Spread on Corporate Bonds EDWIN J. ELTON MARTIN J. GRUBER DEEPAK AGRAWAL and CHRISTOPHER MANN ABSTRACT The purpose of this article is to explain the spread between rates on corporate and government bonds. We show that expected default accounts for a surprisingly small fraction of the premium in corporate rates over treasuries. While state taxes explain a substantial portion of the difference the remaining portion of the spread is closely related to the factors that we commonly accept as explaining risk premiums for common stocks. Both our time series and cross-sectional tests support the existence of a risk premium on corporate bonds. The purpose of this article is to examine and explain the differences in the rates offered on corporate bonds and those offered on government bonds spreads and in particular to examine whether there is a risk premium in corporate bond spreads and if so why it exists. spreads in rates between corporate and government bonds differ across rating classes and should be positive for each rating class for the following reasons 1. Expected default loss some corporate bonds will default and investors require a higher promised payment to compensate for the expected loss from defaults. 2. Tax premium interest payments on corporate bonds are taxed at the state level whereas interest payments on government bonds are not. 3. Risk premium The return on corporate bonds is riskier than the return on government bonds and investors should require a premium for the higher risk. As we will show this occurs because a large part of the risk on corporate bonds is systematic rather than diversif iable. The only controversial part of the above analyses is the third point. some authors in their analyses assume that the risk premium is zero in the corporate bond Edwin J. Elton and Martin J. Gruber are Nomura Professors of Finance Stern School of Business New York University. Deepak

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