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IAI Actuarial Core Principles · Economic Modelling · Simple models for credit risk

Which statement about observed credit spreads on corporate bonds relative to government bonds is correct?

Observed credit spreads typically exceed expected default losses because they also compensate investors for bearing default risk and lower liquidity, not just average loss. Risk-neutral default probabilities backed out from spreads are therefore usually higher than real-world ones.

  1. AThey reflect only the expected loss from default under real-world probabilities
  2. BThey are normally zero for investment grade bonds
  3. CThey typically exceed the expected default loss because they also compensate for risk premia and liquidityCorrect
  4. DThey fall when the recovery rate falls, other things equal
  5. They are independent of the bond's term

Explanation

Observed spreads include compensation for expected default loss plus a risk premium for default uncertainty and for lower liquidity, so they usually exceed the real-world expected loss. A lower recovery rate raises the spread, not lowers it.

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