Breakdown of the excess yield of corporate bonds over treasury bonds

[actually an Actuary]

Hi guys,
In Chapter 3 of the notes there is a section that reads.......
The excess of the yield on corporate bonds over Treasury bonds is typically
decomposed into four components:
1. Compensation for expected defaults.
2. Investors may expect future defaults to exceed historic levels.
3. Compensation for the risk of higher defaults, ie a credit risk premium.
4. A residual that includes the compensation for the liquidity risk — typically
referred to as an illiquidity premium.

What is the difference between point 2 and 3?

 

[Colin McKee]

The difference between these is quite tenuous. I think in CAPM theory, there is a risk premium in respect of expected volatility and uncertainty (possibly caused by the uncertainty of future credit events). This is point 3 above. In addition, if you actually think there is a Y% chance that the bond will default and you will lose your money, you will factor this Y% loss into your price calculation. This is point 2. They are both similar, but one is compensation for the uncertainty and risk of future credit events, and the other is for anticipated or predicted losses.

 

[Akshay Baheti]

Then, what is the difference between point 1 and point 2??
Because under both scenarios, we are factoring in the risk of defaults.?

The difference between these is quite tenuous. I think in CAPM theory, there is a risk premium in respect of expected volatility and uncertainty (possibly caused by the uncertainty of future credit events). This is point 3 above. In addition, if you actually think there is a Y% chance that the bond will default and you will lose your money, you will factor this Y% loss into your price calculation. This is point 2. They are both similar, but one is compensation for the uncertainty and risk of future credit events, and the other is for anticipated or predicted losses.