2009coursenote-CA1-Chapter36-page8-example

Chapter 36 on page 8 gives the following example:

Government yield = 4%.
Corporate bond yield = 5.5%.

So, additional yield over the gov.bond yield is 1.5%.
1.5% includes 1% for credit risk and 0.5% for marketability risk.
The discount rate used is 4.5%.

Question 1, why do we strip out the credit risk element (1%), when we set assumption?

The corporate bond is risky so investors demand a higher return as compensation. The company might default (credit risk), or it might be difficult to sell the bond due to the small number of bonds in issue (marketability risk).

However, we are looking to discount our liabilities at a risk-free rate, so the rate of 5.5% is too high for this purpose. We must subtract 1% to remove the effect of credit risk.

Question 2, why do we include the marketability risk element (0.5), when we set assumption even assets are intended to be held rather than sold?

If we intend to hold the bond to maturity then it does not matter whether the bond is marketable or not. There is no need to reduce the returns by 0.5% for marketability risk. The risk-free return is 4.5%.

If we did intend to sell the bond in future then we would need to reduce the yield for marketability risk.

So the risk-adjusted return is higher for long-term investors than short-term investors, and so this bond will be relatively more attractive to long-term investors.

Question 3, in what circumstances, will we include the credit risk element but strip out the marketability risk element?

We would never include the credit risk element as all investors are exposed to this risk.