Does The Investor Get Compensated for Investing in Risky Corporate Bonds?

Abstract: This study investigates if the investor in US corporate bonds gets sufficiently compensated for default risk. This is done by examining the expected excess return for corporate bonds across varying levels of default probability. By discounting expected cash flows and using three different bankruptcy prediction models to estimate default probabilities, namely Hillegeist et al. (2004), Ohlson (1980) and Shumway (2001), we find that the investor does in fact not get compensated for investing in the riskiest segment of corporate bonds. The results are also consistent when applying historical default probabilities implied by credit ratings.