We support the hypothesis that the entire ex ante default risk premium on original-issue, low-grade bonds is justified by actual ex post default losses and that the initial risk premium fairly and efficiently compensates investors for ex post default losses.
(2.) The issue of whether low-grade bonds fairly and efficiently price default risk is important since this market is an important source of capital for many firms.
Keim, 1991, Realized Returns and Defaults on Low-Grade Bonds: The Cohort of 1977 and 1978, Financial Analysts Journal, 47(2): 63-72.
Return and volatility of low-grade bonds
Green, 1991, "The Investment Performance of Low-grade Bonds Funds," Journal of Finance (March), 29-48
Kihn, J., 1994, "Unravelling the Low-Grade Bond Risk/Reward Puzzle," Financial Analysts Journal (July/August), 32-42.
In discussing his study of low-grade and high-grade bond performance, Regan (1990) reports that the low-grade bond portfolio performed consistently well except during a recession, that junk bonds displayed the same seasonal pattern as second-tier stocks, including the "January effect;" that both low-grade stocks and low-grade bonds reflect the riskiness of the individual firm rather than changes in the general market, that the yield spread was not useful in timing business cycles, and that junk bonds behaved more like equities than like Treasury bonds.
Liquidity and the Pricing of Low-Grade Bonds. Financial Analysts Journal, 48(January/February): 63-67, 74.
Expanding on Bookstaber and Jacob's work, Ramaswami (1991) reports success with a portfolio hedging strategy "based on the proposition that a high-yield bond is a dynamic combination of equity and riskless bonds." Cornell and Green (1991) find that "movements in stock prices explain a larger fraction of the variance of low-grade bond returns than do movements in interest rates." Shane (1994) creates an index of 208 low-rated bonds and an index of the stocks of the issuers represented in the bond portfolio.
Green, 1991, "The Investment Performance of Low-grade Bond Funds," Journal of Finance (March), 29-48.
Keim, "Realized Returns and Defaults on Low-Grade Bonds
1977-1989," Journal of Finance (March 1991), pp.