Principles of Managerial Finance

272 PART 2 Important Financial Concepts

Because the U.S. Treasury bond would represent the risk-free, long-term security,

we can calculate the risk premium of the other securities by subtracting the risk-

free rate, 5.68%, from each nominal rate (yield):

These risk premiums reflect differing issuer and issue risks. The lower-rated cor-

porate issues (speculative) have a higher risk premium than that of the higher-

rated corporates (high quality and medium quality), and the utility issue has a

risk premium near that of the medium-quality corporates.

The risk premium consists of a number of issuer- and issue-related compo-

nents, including interest rate risk, liquidity risk, and tax risk, which were defined

in Table 5.1 on page 215, and the purely debt-specific risks—default risk, matu-

rity risk, and contractual provision risk, briefly defined in Table 6.1. In general,

Security Risk premium

Corporate bonds (by ratings):

High quality (Aaa–Aa) 6.13% 5.68%0.45%

Medium quality (A–Baa) 7.14 5.68 1.46

Speculative (Ba–C) 8.11 5.68 2.43

Utility bonds (average rating) 6.99 5.68 1.31

TABLE 6.1 Debt-Specific Issuer- and Issue-Related Risk

Premium Components

Component Description

Default risk The possibility that the issuer of debt will not pay the contrac-

tual interest or principal as scheduled. The greater the uncer-

tainty as to the borrower’s ability to meet these payments, the

greater the risk premium. High bond ratings reflect low

default risk, and low bond ratings reflect high default risk.

Maturity risk The fact that the longer the maturity, the more the value of a

security will change in response to a given change in interest

rates. If interest rates on otherwise similar-risk securities sud-

denly rise as a result of a change in the money supply, the

prices of long-term bonds will decline by more than the prices

of short-term bonds, and vice versa.a

Contractual provision risk Conditions that are often included in a debt agreement or a

stock issue. Some of these reduce risk, whereas others may

increase risk. For example, a provision allowing a bond issuer

to retire its bonds prior to their maturity under favorable

terms increases the bond’s risk.

aA detailed discussion of the effects of interest rates on the price or value of bonds and other fixed-income

securities is presented later in this chapter.