FACULTY OF BUSINESS AND ECONOMICS

SEMESTER 2, 2021/2022
CIC2007 MONEY AND BANKING
OCC 1 (TUESDAY, 9AM - 12PM)
GROUP 4
GROUP ASSIGNMENT (15%)
LECTURER: DR. SHAHRIN SAAID BIN SHAHARUDDIN

PREPARED BY:

Group Members Matrics Number Student ID

TAN CHIN KIET CIB190102 17206698/1

OOI YONG YIE CIB190086 17207161/1

PHANG JIE XIAN CIB190088 17204963/1

LIANG WAI LUN CIB190045 17207431/1

WONG JING NI CIB190121 17207547/1

Presentation Slide Link:

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Video Presentation Link:

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 Table of Content

1.0 Introduction 1

2.0 The factors that cause risk premiums on corporate bonds anticyclical 2

2.1 Economic conditions 2

3.0 The Historical Market Risk Premium 4

4.0 The Consequences of a Cyclical Risk Premium on Corporates Bonds 5

4.1 Economic Collapse 5

4.2 Reduced Investment of Corporate Bonds 5

5.0 Conclusion 7
1.0 Introduction

Corporate bonds are bonds issued by companies. Investors who buy corporate bonds lend

money to companies. Treasury bonds or government bonds are government debt securities

issued by the government. Both corporate bonds and treasury bonds are a good investment for

investors looking for safety and a fixed rate of interest.

The main difference in terms of risk between corporate bonds and treasury bonds or

government bonds is default risk. Default risk is the possibility that the lender will presume

that the borrower will not be able to pay back the debts. The default risks increase due to

increase in uncertainty in the market. Treasury bonds are used as benchmarks by the market

because they have no default risk while corporate bonds all have some level of default risk.

Because of default risk of corporate bonds, there are risk premiums on corporate bonds. Risk

premiums are additional rewards to compensate investors for the additional risk they take. Risk

premiums on corporate bonds are usually anticyclical which means the risk premiums on

corporate bonds will decrease during economic boom and increase during recessions.

When there is an economic boom, the companies have the highest earnings potential so default

risks will decrease and risk premiums on corporate bonds will decrease. However, during

recessions the companies will face challenges in their business operations due to the significant

reduction in profit so risk premiums on corporate bonds will increase.

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2.0 The factors that cause risk premiums on corporate bonds anticyclical

2.1 Economic conditions

When an economic boom occurs, very few of the businesses go bankrupt because it is the phase

in which the companies have the highest earnings potential. Most businesses are operating at

full capacity because inflation usually occurs during this period, which allows businesses to

raise prices when demand exceeds supply and the market provides investors with high returns.

During an economic boom, the default risks reduce because economic expansion increases the

revenues and earnings of the companies which allow the company to offer low yield on its debt.

As the economy enters a period of expansion, investor confidence rises as a result of the strong

economy and the ability of businesses to generate profits. Thus, they are willing to buy

corporate bonds at a lower risk premium as the risk of these investments are lower. In an

expanding economy, borrowers are more likely to repay their debts because during an

economic boom, the risk premium will fall and making it easier for borrowers to pay interest

payment on their debt on time and increasing the chances for businesses to pay their debt in

full.

Meanwhile, the contraction of the economy will affect the whole economic system as the

unemployment rate will increase while the consumer's spending will decrease. This indicates

that the businesses will face challenges in their business operations due to the significant

reduction in profit during the recession.

Businesses encounter challenges managing their operations during a recession because

economic activity is slowing down. Due to the low levels of investor confidence, they attempt

to offset risky investments by charging a high risk premium. This will increase the default risks

as the impact of recession on companies’ revenue and earnings can affect their ability to pay

interest on debt.

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Since the default risks increase due to increase in uncertainty in the market, the increased risk

premium acts as a compensation for investors. Therefore, it will provide opportunities to

investors, especially those who are risk-takers. Hence, the high-risk premium will attract the

investors to undertake the risks to generate higher return on investment (ROI).

In conclusion, during an economic expansion, real GDP, output, aggregate demand, income

increase, and business activity rise, which reduces the default risks and thus lowers the risk

premium. While during a recession, real GDP, output, aggregate demand, and income decline,

and business activity declines, which increases the default risks and thus the risk premium

increases. These are the reasons why the risk premium on corporate bonds is anti-cyclical.

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3.0 The Historical Market Risk Premium

Referring to the graph above, the measure of risk premiums is anticyclical throughout 40 years.

The risk premium rises during recession and vice versa. The significant change in risk premium

occurred in 2008 to 2009, during the Great Recession period, the sharp rise in poverty rate,

followed by the Global Financial Crisis happened due to the U.S. housing bubble. Hence, the

risk premium rises or falls in response to the economic conditions.

During an economic boom, the risk premium is much lower compared to the recession period.

The investors are expected to receive lower returns as the economy grows rapidly. When the

economic condition turns bad, the risk premium will become higher as investors need to bear

higher risk in the corporate bond. Therefore, the high-risk premium will encourage the

investors to take risk in generating a higher rate of returns.

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4.0 The Consequences of a Cyclical Risk Premium on Corporates Bonds

4.1 Economic Collapse

If the risk premium on corporate bonds is always cyclical in an economic boom where the

bonds tend to follow the upward trends in the economy, it will lead to an economic collapse.

Generally, the companies make a lot of money during this period because the economy is

expanding, where this will provide confidence to the investors, as the risk of investing in

corporate bonds is lower. If the risk premium on corporate bonds is cyclical during an economic

boom, the investors could gain a higher risk premium that is associated with a lower risk. As a

consequence, all the investors will move their investments into corporate bonds as it could

provide them a higher return but with a lower risk, and indirectly this will lead to inflation. To

tackle this high inflation, the government needs to pursue tight monetary policy by imposing

high-interest rates. This increase in interest rates caused a fall in aggregate demand and

recession.

4.2 Reduced Investment of Corporate Bonds

During an economic recession, if the risk premium is cyclical in nature, this situation will

reduce the investor’s investments in corporate bonds. In general, the risk premium of corporate

bonds will become higher and offer investors with a higher return that is associated with higher

risks during a recession. Just assume that if the risk premium of corporate bonds is cyclical and

it becomes lower during an economic downturn, the investors are going to face higher risks

that generate a lower return for them when they are investing in corporate bonds. As corporate

bonds are a form of debt financing of businesses, reduced investments in corporate bonds also

mean that the businesses are not able to finance the money from the investors anymore. This

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situation is worsening as it happens during economic recession where businesses are facing

pressure on their sales and profit, and it will eventually lead to a vicious circle.

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5.0 Conclusion

In summary, it is correct to say that the risk premium is anti-cyclical in nature when we refer

to historical evidence. During an expansionary phase, the country’s economy is growing

strongly and most businesses are capable of making profits. Investors are confident with the

future outlook of economic and business growth, so they are willing to take corporate bonds at

a lower risk premium. The borrowers and businesses would be more willing to repay their debts

during economic expansion, thus there will be low default risks. During a recession, on the

other hand, many business activities slow down and consumers are less willing to spend money.

Investors are less confident about the future outlook, so risky investments will require a high

risk premium to compensate those investors. Furthermore, during economic downturns,

businesses are unable to generate high profits and earnings, affecting their ability to repay debts.

Due to the overall market's uncertainty, default risk and risk premiums will rise.

If assuming the risk premium of corporate bonds is cyclical, it will bring negative consequences

on the business environment. For instance, if investors demand more corporate bonds but they

have high risk premiums, this will indirectly cause inflation during an economic boom phase.

Investors' investment in corporate bonds will decline during a recession due to low risk

premiums. This means that investors face higher risk but lower returns on risky investments.

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treasury-bonds-interest-rates-risk-spreads/

Hayes, A. (2021, December 13). Risk premium. Investopedia.

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Kagan, J. (October 19, 2020). Default Risk. Retrieved from

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