AN ALTERNATIVE TO THE YIELD SPREAD AS A MEASURE OF RISK.

Both in the theoretical and applied literature of finance the difference in yield-to-maturity between corporate bonds and government bonds has been used as a measure of the incremental riskiness of the former over the latter. While this approach has sometimes provided interesting results, the usefulness of yield spreads is lessened by inherent biases and implicit assumptions as to the pattern of risk adjustment for future promised cash flows. This article presents an alternative measure of the incremental risk compensation process over time on risky bonds. The proposed alternative views the risky bond price as the discounted present value of future certainty equivalent payments. The certainty coefficient, which is the ratio of certainty equivalent to promised payment, gives an implicit measure of risk adjustment for a given future payment period. Time series movements in the overall vector of these coefficients (empirically derived at each point in time for a number of future promised payment periods) within a given risk class represent a dynamic picture of changing risk compensation. The general methodology of this paper centers upon the estimation of single equation regression coefficients for the certainty coefficient variables and for additional variables representing marketability, callability and tax characteristics for bonds in a given risk class. Agency ratings are used to approximate equivalent risk classes and the Almon regression-interpolation procedure is used to estimate structures of certainty coefficients annually from 1952 to 1964. The empirical results over this period for investment grade bonds confirm the usefulness of the approach. The study furthermore indicates that, while call options and taxes have the expected effect on bond prices, marketability, as defined, has little impact. This outcome has important implications for the use of marketability measures and risk classes and for the apparent efficiency of the bond market. [ABSTRACT FROM AUTHOR]