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Explaining the Rate Spread on Corporate Bonds

Authors

  • Edwin J. Elton,

  • Martin J. Gruber,

  • Deepak Agrawal,

  • Christopher Mann

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    • Edwin J. Elton and Martin J. Gruber are Nomura Professors of Finance, Stern School of Business, New York University. Deepak Agrawal and Christopher Mann are Doctoral Students, Stern School of Business, New York University. We would like to thank the Editor, René Stulz, and the Associate Editor for helpful comments and suggestions.

ABSTRACT

The purpose of this article is to explain the spread between rates on corporate and government bonds. We show that expected default accounts for a surprisingly small fraction of the premium in corporate rates over treasuries. While state taxes explain a substantial portion of the difference, the remaining portion of the spread is closely related to the factors that we commonly accept as explaining risk premiums for common stocks. Both our time series and cross-sectional tests support the existence of a risk premium on corporate bonds.

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