Principles of Corporate Finance_ 12th Edition

Chapter 3 Valuing Bonds 67

bre44380_ch03_046-075.indd 67 10/08/15 10:45 AM

Because of the risk of default, yields on corporate bonds are higher than those of govern-
ment bonds. For example, Figure 3.9 shows the yield spread of corporate bonds against U.S.
Treasuries. Notice that the spreads widen as safety falls off. Notice also how spreads vary over
time. They widened dramatically, for example, during the credit crunch of 2007 to 2009.^16

Sovereign Bonds and Default Risk

When investors buy corporate bonds or a bank lends to a company, they worry about the pos-
sibility of default and spend considerable time and effort assessing differences in credit risk.
By contrast, when the U.S. government issues dollar bonds, investors can generally be confi-
dent that those bonds will be repaid in full and on time. Of course, bondholders don’t know
what that money will be worth. Governments have a nasty habit of reducing the real value of
their debts by inflationary policies.
Although sovereign debt is generally less risky than corporate debt, we should not leave
you with the impression that it is always safe even in money terms. Indeed, as the nearby box
explains, even in the United States investors in government bonds have had their scary moments.
Countries do occasionally default on their debts and, when they do so, the effects are sometimes
catastrophic. We will look briefly at three circumstances in which countries may default.

Foreign Currency Debt Most government bond defaults have occurred when a foreign gov-
ernment borrows dollars. In these cases investors worry that in some future crisis the govern-
ment may run out of taxing capacity and may not be able to come up with enough dollars to
repay the debt. This worry shows up in bond prices and yields to maturity. For example, in
2001 the Argentinian government defaulted on $95 billion of debt. As the prospect of default

(^16) Corporate bonds are also less liquid than Treasuries: they are more difficult and expensive to trade, particularly in large quantities or
on short notice. Many investors value liquidity and will demand a higher interest rate on a less liquid bond. Lack of liquidity accounts
for some of the spread between yields on corporate and Treasury bonds.
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Some sovereign
defaults
◗ FIGURE 3.9
Yield spreads between
corporate and 10-year
Treasury bonds.

• 1

0

1

2

3

4

5

6

7

Spread on Baa bonds

Spread on Aaa bonds

Yield spread between corporate and

government bonds, %

Apr. 1953Mar. 1956Feb. 1959Jan. 1962Dec. 1964Nov. 1967Oct. 1970Sep. 1973Aug.1976July. 1979June.1982May. 1985Apr. 1988Mar. 1991Feb. 1994Jan. 1997Dec. 1999Nov. 2002Oct. 2005Sept. 2008Aug. 2011July

. 2014