CHAPTER The Risk and Term Structure of Interest Rates Price of Bonds, P 115 Price of Bonds, P ST Sc P T2 i T2 (i T2 ) Risk Premium P c1 (i1c ) P c2 (i2c ) P T1 (i1T ) i c2 D c2 D c1 Quantity of Corporate Bonds (a) Corporate bond market FIGURE 6-2 D T1 DT2 Quantity of Canada Bonds (b) Default-free (Canadian government) bond market Response to an Increase in Default Risk on Corporate Bonds An increase in default risk on corporate bonds shifts the demand curve from D c1 to D c2 Simultaneously, it shifts the demand curve for Canada bonds from D T1 to D T2 The equilibrium price for corporate bonds falls from P C1 to P C2, and the equilibrium interest rate on corporate bonds rises to i C2 In the Canada bond market, the equilibrium bond price rises from PT1 to P T2, and the equilibrium interest rate falls to i T2 The brace indicates the difference between i C2 and i 2T, the risk premium on corporate bonds Canada bond while its relative riskiness rises, the corporate bond is less desirable (holding everything else equal), and demand for it will fall Another way of thinking about this is that if you were an investor, you would want to hold (demand) a smaller amount of corporate bonds The demand curve for corporate bonds in panel (a) of Figure 6-2 then shifts to the left, from D c1 to D c2 At the same time, the expected return on default-free Canada bonds increases relative to the expected return on corporate bonds while their relative riskiness declines The Canada bonds thus become more desirable, and demand rises, as shown in panel (b) by the rightward shift in the demand curve for these bonds from D T1 to D T2 As we can see in Figure 6-2, the equilibrium price for corporate bonds falls from P c1 to P c2, and since the bond price is negatively related to the interest rate, the equilibrium interest rate on corporate bonds rises to i c2 At the same time, however, the equilibrium price for the Canada bonds rises from P T1 to P T2 , and the equilibrium interest rate falls to i T2 The spread between the interest rates on corporate and default-free bonds that is, the risk premium on corporate bonds has risen from zero to i c2 * i T2 We can now conclude that a bond with default risk will always have a positive risk premium, and an increase in its default risk will raise the risk premium Because default risk is so important to the size of the risk premium, purchasers of bonds need to know whether a corporation is likely to default on its bonds This information is provided by credit-rating agencies, investment advisory firms that rate the quality of corporate and municipal bonds in terms of the probability of default Table 6-1 provides the ratings and their description for the two largest credit-rating agencies, Dominion Bond Rating Service (DBRS) and Standard & Poor s Corporation (S&P) in the United States, Moody s Investor Service and Standard & Poor s Corporation provide similar information Bonds with relatively low risk of default are called investment-grade securities and have a rating of BBB