As recently as a early 2007 ago there was very little “risk premium” between debt of varying quality. The risk premium is usually measured against US Government debt (Treasuries) of equivalent duration (i.e. a 5 year bond compared to a 5 year security). For instance, if the Treasuries were yielding 5%, then high-quality (at the time) corporate debt might be issued at 6%, with riskier debt as high as 9% (a premium of 4%).
At the time I wrote that this absence of a risk premium was unusual and meant that buyers of debt were being paid very little (beyond what they’d get for a risk-free government issue) for taking on the business risk tied to these often highly leveraged, cyclical businesses. As it would later turn out, these yields were far too low, and since have widened to historically high levels. For example, while Treasuries are around 5% now, “junk” bond yields for new issues are near 20%, which is an amazing premium of 15% or so.
Some analysts are saying that these yields are TOO high (i.e. the market is demanding too much for the level of risk that you are taking on). By their reckoning, companies would have to default at a rate that they didn’t even approach during the great depression in order to justify these yield levels. Others are recommending that this might be a good time to jump in at these levels.
While their calculations of required failures do indeed seem high, the analysts have failed to take one CRITICAL variable into account – the absence of liquidity – essentially they are only modeling the risk of default in isolation.
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