An Analytic Model of Bond Risk Differentials

Author(s): Harold Bierman, Jr. and Jerome E. Hass

Reviewed work(s):
Source: The Journal of Financial and Quantitative Analysis, Vol. 10, No. 5 (Dec., 1975), pp.
757-773
Published by: University of Washington School of Business Administration
Stable URL: http://www.jstor.org/stable/2330269 .
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JOURNAL OF FINANCIAL AND QUANTITATIVE ANALYSIS

DECEMBER 1975

AN ANALYTIC MODEL OF BOND RISK DIFFERENTIALS

Harold

Bierman,

Jr.,

and Jerome E.

Hass*

Introduction
There

is

broad

bond purchaser:

the risk

the risk

of interest

are

before

sold

The analysis
risk

default-free

to default

constants

One is

risk

certainty

equivalent

differential

that

the term structure

specifies

sate

him for the first

the risk

and a liquidity

capacity.

an investor
of default,

equiva?

components.

direction

the risk

(starting

would require
given

two

other

Silvers
of default,

Our model of investor

that

examine

the certainty

considerations.

the risk

differential

debt

Silvers'

reflecting

risk.

funds in

We also

of three

probabilities).

factors

value

amounts of successive

consist

version

adjustments

the risk-adjusted

rate.

from the other

and the risk

the

risks,

present

and a firm's

estimated

factors

power).

rate

determines

to the contractual

we obtain

of discount

of these,

of debt

if the bonds

of their

that

affecting

empirically

model and the assumed

a premium for risk-bearing

of these

them an expected
that

loss),

principal

or gain

interest

require

the process

and the factors

the potential

of purchasing

(loss

with the investment

Silvers'

vior

loss

associated

J. B. Silvers

a set

and/or

to give

the risk

exists

interest

sufficient

applying

are

confront

toward the first

investors

the market is

there

states

that

of risk

principal

level

directed

we examine
rate

paper

with a theoretical
factors

(possible

of the model for the cost

In a recent

years.

value

securities,

the implications
lent

paper

interest

equilibrium

is

types

(possible

and price

By assuming

subject

three

changes

maturity),

to the present

equal

that

of default

rate

in this

of default.

on debt

consensus

beha?

to compen-

the probability

of

default.
In his
that

classical

the average

risk

paper

on bond risk

premium depends

premiums,

first

Lawrence

on the risk

that

The comments and suggestions

Both, Cornell
University.
V. Rao, and J. McClain are gratefully
acknowledged.
J. B.
"An Alternative
to the Yield Spread
Silvers,
The Journal of Finance
(September 1973),
pp. 933-955.
757

as

Fisher

hypothesized

the firm will

of J. B. Silvers,
a Measure

of Risk,'

default

on its

variables

bonds

chosen

by Fisher

(as

come over

the past

nine

of equity
(as

out

creditors

forcing
Fisher

defines

will

earnings
sider
this

noted

above

In the third
schedule

graphical

differential

security.

a perpetual
meeting

dependent

bond and

promises

of the expected

(2)

pro?

of a firm under some assumed

investor

that

models

A Graphical

extend

the

Analysis

to determine

is

to give

an investor
if his

us assume

an expected

that

(1)

survival

Then the expected

of I dollars

B =

(gjj

using

[1 +

Z
t=l

_ t
-5E_

(and conse?

to the next

to pay annual

payments,

value

in a default-

the bond under discussion

from one period

interest

present

funds were invested

of the firm's

obligations)

of the risk

the size

of time of survival.

interest

B -

setting
of debt

the probability

(1)

(2)

rate

to the cost

process

section

let

interest

of the length

of a bond that

interest

he would earn

For simplicity
its

probability.
this

con?

of

earlier.

of this

value

debts.

he deems investors

variables

with some mathematical

on a bond necessary

to the present

with?

the firm's

model of this

The Risk of Default:

objective

that

In the next section

relate

capacity

conclude

described

process

The first

we will

and the debt

We will

II.

quently

section

the probability

as

measurable

a graphical

preferences.

value

those

we will

capital

is

are

present

in meeting

and reliability

ratio),

for the firm to meet the payments on its

the aforementioned

cess.

free

of default

the risk

by the firm's

a loss).

in estimating
paper

equal

to take

measured

of time the firm has been operating

by the length

not be sufficient

The variables

of debt

to book value

net in?

of the firm's

(as

leverage

The three

were earnings

of default

of variation

financial

of the bonds.

of the risk

as determinants

years),

measured

obligations

on the marketability

by the coefficient

measured

variability
market value

and second

is

the default-free

is

present

p,

value

the discounted
interest

rate

(l+i)*1

(^

(^

2
of Risk Premiums on Corporate
"Determinants
Lawrence.
Fisher,
Bonds,"
The Journal of Political
Since the capital
Economy (June 1959),
pp. 217-237.
asset pricing
literature
uses the term "risk premium" to describe
the differ?
ence between the expected
rate of return and the risk-free
rate, we use the
term "risk differential"
to describe
the difference
between the contractual
rate and the risk-free
rate.
Both of these

assumptions

will

be relaxed
758

later

in?

in the paper.

i:

and the sum of the infinite

(2)

If this

converges

so that

< 1

equation

"
] - I
[?i?
. " _?_
1+i-p
1+i

at par and pays

bond sells

(2)

p
r~-r

to one,

form:

B = -S(1+i)

(3)

than or equal

less

in equation

series

in closed

can be written

is

of survival,

p, the probability

Since

rate

a contractual

r,

I = rB, equation

(3)

becomes
p
B = rB ^r-fi?
1+i-p
or,

contractual

for the required

solving

r.iillE.iJi.!.
P

(4)

Thus,

(4)

equation

of survival

if the probability
reduces

(4)

present
is

interest

is

equal

(4)

is

sufficient

monetary value

maximizing

of r with respect

that

contractual

investor

has

rate

MM in Figure

to be paid

Taking

might employ.

derivative

the partial

'

1.
the relationship

leverage)

result

in earnings

From the probability

uncertain.

ascertain

the probability

of survival

between

before

distribution

(probability

the amount of interest

The firm's

of survival.

and the probability

which are

inverse
return.

an expected

the type of process

the investor-required
of survival
increases,
4
is depicted
This relationship
by the
decreases.

to determine

and operating

(sales

of interest.

the probability

We next need
that

equa?

to p

interest

labeled

curve

as

rate

to illustrate

d? __
~ -(1+i)
2
dp
P
we see

certain),

= i;

to the default-free

rate

Equation

payments are

Note that

bond.

to
1+i
r = ?-1

the required

for the risky

in order

a default-free

as

value

1 (the

needed

rate

the contractual

specifies

bond to have the same expected

tion

rate,

operations

interest
of earnings

of meeting

and taxes
one can

interest

payments)

the
would intensify
behavior
risk-aversion
by the investor
Introducing
and
the
the
of
survival
risk
between
investor-required
relationship
759

Probability
of Survival

Required Contractual
Rate of Return

Figure
Investor

Required

Contractual

760

Rate

of Return

for all

levels

possible

of Figure

of interest

2, assuming

Let us now turn to the

Most important

is

the fact

of survival

probability

on the debt:

paid

interest

payments,

between

the interest

terest

clockwise

of debt

To determine

2.

around

is

of survival

us to move from Quadrant

set

from Figure

ity

feasible

r*,

the minimura interest

set

The default-risk

1 (denoted

from the first

where p* is

rate

differential

taken

Suppose

rate

the probability

to equation

The solution

course,
terest

line

rates,

that

enables
the

feasibil-

one can de-

shown in the first

(4),

the default
will

the investor's

quadrant

solution

be obtained

2 (denoted

probabil?

QQ) to ascertain
of debt.
(4)

in Figure

3.

Example

interest
risk

rate-survival

of

rate

before

of earnings

and the firm wishes

what is

rate

required

and from equation

. x .

i . i+i
P*

distribution

$0 and $1000

If the default-free

and what is

interest

of Figure

(r* - i)

is

from the equilibrium

uniform between

according

rate

interest

(r , p ) is
o
o

by the market for B

required

III.

at par.

Thus if

p .

probability

MM) with the interest

quadrant

r* .

is

set

probability

of debt.
Figure 3 shows how to combine

and

payment for
is

has a 45?

in

an in?

I or IV,

and pays

I the point

for varying

tracings

annual

depicted

us choose

interest

rate-survival

rate

2 for B

Finally,
return

of an interest

rate-survival

II

Ouadrant

In Quadrant

is

(p)

of survival

outstanding

the

debt,

The relationship

Quadrant

The implied

probability

po .

is

the debt.

the promised

let

of either

axis

of debt

to I.

By successive

QQ.

the interest

of Figure

III

to be determined

point

velop

dollars

of survival

income.

interest

of survival.

relationship,

the four quadrants.

par value

r , the probability
o

ity curve

this

and the corresponding

the firm has B

first

and probability

(r)

the higher

rate,

the probability

say r , on the horizontal

rate,

trace

rate

to the contractual

the interest

III

than earned

of outstanding

level

related

inversely

and the lower

I of Figure

quadrant

is

shown in quadrant

other

to the firm issuing

for a given

that,

is

resources

available

options

the larger

This

payments.

the firm has no cash

is

to sell

4 percent

the minimum acceptable

differential
algebraically.

interest

and taxes

$300 worth of bonds

and investors
equilibrium

behave
interest

the company must pay?

From the above

suppositions

Should MM and QQ cross more than once, the lower or lowest r is, of
rate since the firm would have to pay higher in?
interest
the correct
costs at all other r's.
761

1 h

<V*o>

Figure
The Interest

Rate

- Survival

762

Probability

Set

i r71

Figure
Equilibrium

Interest

763

3
Rate

Determination

the following

follow:

relationships
I = 300 r
I ? 1000 - 1000 p

The investor

(a)

requirement

IV)

(quadrant

III)

MM, can be obtained

curve,

from

directly

(4):

equation

1 + .04
p
The firm's

(b)

(quadrant

tradeoff

set,

I - 300 r and I = 1,000

1.04
p

QQ, is
- 1,000

obtained

/MM.

the equations

by solving

for p in terms of r:
300 r = 1000 - 1000 p
1000 - 300 r 1 - .3 r
1000
(c)

the two equations

Taking

for r we find that

taneously

the higher

ignoring

r* = 5.8%,

and the risk

The probability

The Cost

The model presented

the cost

of debt

approach

would be to solve

outstanding,
firm's

capital

survival

probability

Hence

for a given

until

MM and QQ are

investor
tangent,

are

= 5.8% - 4% * 1.8%.

= 0.983.

of Debt and Debt Capacity

section

and the debt

repeatedly

B, to find the cost

simul-

is:

in the preceding
schedule

and solving

root,

p* ? 1 - .3 r* - 1 - .3(.058)

IV.

above

2.275)

differential

of survival

(b)

the two roots

r = (.058,
so that,

and

from (a)

(QO)

to determine

for a given

capacity

for r* as we systematically

of debt

schedule,
curve

feasibility
preference

can be used

curve,

QQ of Figure
MM, r*(B)

and the corresponding

764

r*(B).

firm.

3 shifts

B, denoted

rise

One

vary the debt

As B increases,

will

both

the

inward.

as B increases

B*
, is
max

the

firm's
est

debt

rate

r*(B

it will

max),

An equivalent

(see

Fiqure

move counterclockwise
ket interest

(r ,1 ) in Quadrant
o o
investor

curve

iR which is

labeled

of debt

of the debt

ment that

is

to carry

rate

r .

we obtain

of r*(B

Thus if B

IV.

amount of debt will

).

debt
debt

The firm's

schedule

(mix of debt

ing such a schedule,

the above

mummarket value

of the firm.
over

any earnings

financinq)

analysis
debt

also

in the above
interest

into

Aside

issued
is

capacity

require-

B
is
max

model

any capi?

from provid?
to

on the extent

some light

financinq.

the required

input

decision.

sheds

for equity
^

Implicit

and above

a necessary

of course,

is,

and equity

which the firm can substitute

is

not the maxi-

the assumption

payment I are paid

as

dividends.

equity

Thus there
B
) that
max

is

an expected

vary in value

will

dividend
inversely

stream

for any debt

with the debt

level

of corporate
For a general
discussion
Debt Capacity
(Harvard University,
Corporate
g

Richard

Holman suggested

g
Since

r*(B

footnote

5.

this

debt capacity
1961).

B (including

While

level.

and QQ shifts
inward,
Referring to Figure 3, as B increases
down MM, so that r*(B) increases
of QQ and MM slides
intersection

See

is

in an interest

result

level

by the intersec-

determined

is

in Quadrant

rate

a promised

rate

offer

For any given

and the market would accept.

interest

for

the

the firm could

that

I)

us

in Quad?

By starting

the process,

(r,

let

amount of interest

a feasible

interest

of points

and iR curve

a larqer
^

of debt

structure

that

with probability

defining

(r ,p ),

to determine the marQ

The point
p .

III

and Quadrant

the firm

not feasible.

The cost
tal

the set

promised

curve

since
to B
max

equal
1

II

inter?

schedule,

preference

on MM, say

a point

of r and repeating

bond issues

the equilibrium

it would have

one point

values

the investor

can be paid

and a given

preference

to the market via

tion

IV is

I with different

rant

) that

(I

at

because
than B
max
7
requirements.

Choosing

through Quadrant

payment

debt

any more debt

return-probability
4).

to hold

willing

method would be to place

I

MM, in Quadrant

given

not purchase

meet the investors'

cannot

the market is

While

capacity.

see

further

the relevant
as B increases.

G. Donaldson,

method of analysis.

) < r , the firm will

o

765

issue

bonds

at r*(B

) rather

than r .
o

I->^

r*(B o )

Figure
The Cost

of Debt

r*(B

max

and Debt Capacity

766

of this

exploration
are

facet

of the problem

is

a few comments

here,

inappropriate

in order:
(1)

If excess

in periods

obligations

investors

payments,
over

than,

In discussing

(3)

increases

optimal

can issue

but an equity
as

While

long as

the above

result

ences

can be incorporated

resultant

MM curve

would depend

first

section

we shall

lowing

a principal

ascertaining

the equilibrium

vival

and examine

These

two extensions

MM above,
Let p

denote

decision

The extent

to which the investor

the Survival

is

and

and the

process

of the shift

risk

adverse

considerations)

and

implicit

Assumptions

change

that

interest

the bond has

rate

a more realistic
the probability

assuming

affects

of surviving

attached;

finite

in two ways:

period

we shall

upon past
interest

the market trade-off

each

after

second,

maturity,

conditional

indifference

by al?

maturity

the equilibrium

model affect
investor

infinite

measure

of survival,

modification

of the previous

of the model

the assumptions

of probabilities

how this

making it

the

solely

Risk prefer?

assumption.

to the right.

(portfolio

remains.

the methodology

considerations,

repayment with a probability

for the revision

are

preferences

on that

some mar?

on stock

the investor's

the assumption

allow

remain and carry

a firm

income stream.

we shall

relax

the amount of debt

into

possibilities

V. Relaxing
In this

investor

Income limi-

shift

on the extent

on diversification
in the firm's

would

many theorists

firm."

of a dividend

do not rely

conclusions

qualitative

limit

may still

monetary value

operations

considerations,

debt-financed
will

assumes

when the prob?

constant.

remaining

some probability

analysis

of expected

"all

residual

of survival

time with successful

structure

preferences

ket value

to meet debt

behavior

preference

assumed,

the virtually

and investor

not sufficient

future

B
would correspondmax
in the
complexity
indirectly

this

over

capital

in meeting

effect.

investor

as previously

have discussed
tations

"cushion"

by examining

to assist

upward the probability

We approach

of survival

ability
rather

when income is
this

be increased.

next section

in order

retained

would revise

time reflecting

ingly

(2)

are

earnings

sur?

rate.
curve

locus.
(and consequently

If the bondholders
were risk averters,
the MM curve in quadrant I of
RR curve would fall- below the
its corresponding
Figure 4 would be flatter;
one in quadrant IV and the consequent
of debt and the
maximum level
existing
promised interest
payment (I) would be less than it would in the absence of
risk aversion
and the expected equity dividend
greater.
767

debt

meeting

interest

of collecting

probability
and N denote
ing at par

the final

the length
is

B.

investors

Assuming

monetary value,
curity

the default-free

rate

on the debt,

is

r,

both sides

Dividing

is

outstanding,

The market price

between

debt

denote

the

at maturity,

of the debt

on the basis

sell-

of expected

in a riskless

investing

i and this

rate

payment and principal

make decisions

be indifferent

if the promised

se?
interest

such that
B =

(5)

interest

of time to maturity.

they will

yielding

the debt

while

payments)

N"1
Plfc rB
Pl"1 P2(1+r)B
+ -!-2_Z -i-E|
t-1 (1+i)
(1+i)

by B and rewriting

formulas,

(5)

equation

using

known geometric

sum

N-l
r

1+i

P2(1+r)

Pj"1

cX)
vl+i'

(l+i)N

?-or
r
Pl
??S?r X
Pl

(6)

Solving

(6)

N-l " ,,,..N-1

U+l)
Pl
-;n(l+i)N_1

for r we find

(7)

- (1+1)

P1(l+l)[p1
if we divide

- 1 - i)
(p_
i

- p*""1 p ]
i
z

[(l+i)N
r - ?

Note that

N-l
-N =
1*
pY
p?2 (1+r) (1+i)
X

the numerator

] +

P;L

P2[P1-1-1]

and denominator

of equation

(7)

by (1+i)

we find
r -

P9z U+i)~NJ

U-P*-1
^
p?

(1+i)

-Px

Px

(P,L

- 1 - i)

P2(P1-l-i)(l+i)

and
= -Pl

lim r
n*-

which is

our earlier

any length
If

P-.-p^p,

-pi

equation

of maturity
equation

" * " i

(N)
(7)

(4).

X + i "
Pl
= -=-1
Pl

Equation

if the probability

reduces

to equation

768

(4),

1+i

in fact,

of survival
(4)

Pl

as

holds
is

follows:

for a bond of

constant

over

time.

r(Pl

- P)

P2

N - N
p ]

[(1+i)
-= ?-?

(p-l-i)
N
N
(l+i)
p + p (p-l-i)

p (l+i)

N - N
[(l+i)"
p"] (p-l-i)
_l. N+1
- /-.^?xN
(l+l)
p + p

N - N
[(l+i)*
p"] (p-l-i)
rn?MN - N_
- p[(l+l)
p ]

or

(4)

r(p.
the risk

Thus,
tors

maximize

constant
is

invariant

One explanation

changes

since

ment is

exactly

with the life

net monetary value

to change

vious.

est

invariant

The result

time.

1+i

- *?

is

differential
expected

over

= p)

p2

the change
offset

and the probability

of survival
is
= p = p, the risk differential

that,

of time to maturity

the risk

that

in the expected

by the change

differential
present

does

value

in the expected

not intuitively

is

not change

of the principal
present

value

ob?

as maturity
repay-

of the inter?

payments.
Suppose the maturity date is put off from N to N + M. Then the change
in the net expected present value of the principal
repayment is

(loss)

?N+M
?B
P
N+M
(1+i)
while

the change

(gain)

N
P B

P B
N
(1+i)

1]

N I(rfi?

(1+i)

in the net expected

present

value

of the interest

ment is
N+M
n t
rB
P
E
t=N+l (l+i)11

= Br P

(l+i)N

M
t-1

N?
= p Br
(l+i)*

(l+i)N

( Pt)
1+i

(-E-)M
1+i

- 1

JL.-1
1+i
M

= rp

Equating

these

two differences

B p
(l+i)1

(i+7>
P - d+i)

we find that
-?EL
P - d+i)

(4)

when p

in the length
is

of the bond when inves?

1+i
r ?-1
P

as we anticipated.
769

pay

Table
p

1 shows the risk

for i = .05;

between

difference
the risk

differential.

to maturity
a given

these

values

were computed using

the risk

increases,

differential

the risk

survival

past
est

over

and/or
While

will

always

fitable

vestment

While
developed,

survived

interest

use

in all

of setting

for

decreases

the probability

suggests,

survival

of

a history

and consequent

inter?

t=l

are

amount of debt.
of return

retained

this

investments,

will

of survival

probabilities
will

in proof

The proportion
earned

determine

on their

the rate

the

change
rein?

at which the

upward.

of the probability
one that

of surviving
t-1 periods.

and if investors
payments discounted

the market price,

N"1

that

if earnings

the rate

revised

a simple

previous

promised

_ _

reflects

revision

process

in period

t is

W+ t

If the bond sells

are

using

be

could

of the procedure.

the spirit

if the firm

at par and pays

the expected

at the default-free

present
rate

i as

value
the

then:

(W+t)1

Sl

rB

(W+N)1 Sl B(l+r)

(S+t)!

W! (1+i)

(W!)

(S+N)!(l+i)

B = rBA + B(l+r)G

(8)

12
David

are

the probability

r on par value,

of the future
basis

as

numerous formulations

Let us assume
has

for a given

of the investment,

of survival

we will

to claim

of survival,

as well

and the nature

probabilities

analysis

in risk-decreasing

curve

retained,

earnings

of revising

of future

dangerous

with length

and invested

of survival

probability
excess

undoubtedly

increase

years

empirical

the probability

as p

Also,

collection.

principal
is

the

increases.

of the effect

As Fisher's

time.

enhances

it

and

and defining

(7)

equation

fails.

differential

We now turn to an examination

of survival

of N, p

values

the contractual
rate (i) as
risky rate (r) and the riskless
12
The table shows that when p > p , as length of time

and maturity,

for different

differentials

The calculations
Downes.

for all

the tables

in this

section

were performed

by

We could also interpret

as one where we do not know the
the situation
of survival,
of the prior probability,
and revise
make an estimate
probability
the probability
as new information
is obtained.
770

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771

(W+t) ! S! ,,...-t
U+l)
(S+t) t Wl

A " N^1
*
t?1

Where

Solving

for r we have

(8)

equation

(W+N) ! S1 ,,L..-N
(1+1>
(S+N)l Wl

, ? "
and G

1 - G
r ?
A + G-

(9)
2 displays

Table
equation

(9)

the risk

for i * .05

of the table

aspects
(i)

and selected

by investors

required

of N, W, and S.

values

implied
are

There

by
three

we wish to highlight:

For any given

2, there

differential

initial

are

the faster
2, the risk

of revision.

Hence,

for the lower

differentials

in Table

W+l *
?=p.?

such that

of W (or S,

the value

p , the lower

the rate

denoted

numbers of W and S pairs

infinite

For any given

of survival,

probability

for any given

W are

S ? W/p ),

since

in Table

than for higher

lower

W's.
(ii)

The initial
the risk
that

differential.

risk

revises

risk

two situations,

variant

are

held

being
is

maturity

repaid

is

time,

higher
time;

case.

772

of survival
- .85

The p

* .8 column since

decreases

under
has

probability

Here,

the probability
of survival

the expected

so the risk

of the

model when
for each

interest

differential

of
was in-

differential

than with the earlier

also

with length

when probabilities

the risk

the probability

for the same reason,

has

in the columns

the values

we found that

over

since

upward over

of collection

2 for N ? 10.

of time to maturity.

lengthened

revises

higher

constant

is possible

the probability

differential

the risk
Earlier

it

with W/S = 85/106.

very slowly

W and S,

to length

principal

compare

determine

not alone

probability

than the p

differential

of time to maturity.
survival

initial

for some N if

For example,

revises

For any given

is

In comparing

? 4/5 ? .8 in Table

and p

of survival

period

p , does

differentials

slowly.

= .85

a higher

(iii)

of survival,

the one with the higher

higher

probability

fails

payment
in this

TABLE 2
VALUES OF RISK DIFFERENTIAL

FROM EQUATION (9)

WHEN i - .05

Conclusions

VI.
The Fisher

specifying

of 1959

paper

differentials.

This

is

paper

the process

and variables

signed

by the market to the debt

ture.

Using

cost

of debt

a partial

laid

an attempt

curve

determine

of a given

the model developed

capital

that

in this

as well

as

for understanding

foundation

to reinforce

and extend
the risk

the debt

we are

limit

as-

struc?

capital

to determine

able

capacity

by

differential

firm with a given

paper

Fisher

risk

the

for any given

firm.
Though this
be classified

than simple

that

affect

step.

expected

gation

payments

ries.

Thus such

factors

in the modeling

as

risk

of investor

of the survival

process

order

ascertain

to better

and size

be neatly

method of analyzing
most likely

Investors

net present

the likelihood
cannot

a unique

introduces

as a first

plex

ered

paper

as

value
(in

into

the cost

changes

over

and limit

773

more com-

criterion

and factors

payment)

of debt

se?

must be consid?

the characterization

time must be enlarged

of debt

obli-

probability

effects

Furthermore,

it must

something

well-behaved

and portfolio

behavior.

and how it

a decision

of partial

case

summarized
aversion

use

debt,

for a firm.

upon in