A comparison of alternative models of the relationship between promised yields on risky bonds and promised yields on risk-free bonds

The main purpose of this study is to compare the expected yields on bonds that are similar in all respects except their default risk, in an attempt to determine whether a relationship exists; and if so, whether the relationship between these yields is best explained by the Yawitz model, the Pye model or the Wu model. If the marginal investors in risky bonds are risk neutral and the bond market is efficient in the sense that promised risky bond yields are grossed up for default risk so that the expected retum equals the investors required retum, then the realized retum on two bond portfolios that differ only with respect to default risk should equal the risk-free rate, on average. This result would be consistent with the model proposed by Yawitz (1977). Conversely, if the marginal investor in risky bond markets is risk averse and bond markets are efficient, then the realized retum on two bond portfolios that differ only with respect to default risk must, on average, vary by a premium to compensate risk averse investors in risky bonds for the uncertainty of the investment. If this additional risk premium is unrelated to the level of the risk-free rate then the results would be consistent with the model proposed by Pye (1974). If this premium varies proportionally with the level of the risk-free rate then the results would be consistent with the model suggested by Wu (1991). If the study provides evidence suggesting the presence of an additional risk premium, additional tests will be conducted to determine whether the premium is stable over time.