Expected Bond Returns and the Credit Risk Premium

A bond's expected return (EBR) is the ex-ante internal rate of return of the bond's expected future cash flows, whereas a bond's yield to maturity (YTM) is the internal rate of return of its promised future cash flows. In this paper we estimate the EBR for a sample of bonds using rating transition matrices and recovery percentages for defaulted states. We apply the model to U.S. corporate bond data, using rating transition matrices and industry-specific recovery rates. We show that ratings largely explain bond maturity-dependent credit risk premia (CRP), defined as the difference between yield to maturity and expected return. This contrasts with the well-known inability of ratings to explain bond yields to maturity