The Credit Risk Premium and Return Predictability in High Yield Bonds

I demonstrate that much of the time series variation in the credit spread on high yield bonds is attributable to changes in the “credit risk premium” rather than changes in expected default losses. The credit risk premium is the expected excess return investors earn from bearing default risk on high yield bonds. I find that the credit risk premium on high yield bonds averages about 2.4 percent per year, accounts for 43 percent of high yield credit spreads, on average, and predicts excess returns on high yield bonds. I also find that the excess returns on lower rated credits (B and CCC, relative to BB) are more sensitive to variation in the credit risk premium. The credit risk premium increases with the conditional volatility of default losses and decreases with aggregate consumption growth. The evidence suggests that conventional measures of economic risk are able to explain the sizeable increase in credit spreads in the fall of 2008.