Credit Risk Premium: Measurement, Interpretation and Portfolio Allocation

Abstract

Investors have two different approaches to the credit risk premium: one based on analytical duration and the other on empirical duration. Fundamentally, the approaches differ on whether the premium should include the effect of Treasury rates on credit bond cashflows. Their different empirical performance reflects the secular decline in rates and the negative relation between rates and credit spreads. In recent decades, the analytical-based premium has poor performance that is offset by providing hedging benefits in a fixed-income portfolio. Conversely, the empirical-based premium has much better performance but does not provide a hedging benefit.