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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*

I.

Introduction

There is broad consensus that three types of risk confront the potential
bond purchaser:

the risk of default (possible interest and/or principal loss),

the risk of interest rate changes (possible principal loss or gain if the bonds
are sold before maturity), and price level risk (loss of purchasing power).
The analysis in this paper is directed toward the first of these risks, the
risk of default.

By assuming that investors require interest rate adjustments

on debt subject to default sufficient to give them an expected present value


equal to the present value associated with the investment of their funds in
default-free securities, we examine the process that determines the risk-adjusted
equilibrium interest rate and the factors affecting that rate. We also examine
the implications of the model for the cost of debt and a firm's debt capacity.
In a recent paper J. B. Silvers empirically estimated the certainty equivalent constants the market is applying to the contractual amounts of successive
years.

Silvers' certainty equivalent factors consist of three components.

One is the risk differential that we obtain from the other direction (starting
with a theoretical model and the assumed probabilities). Silvers' other two
factors are the term structure and the risk version considerations.

Silvers

states there exists a set of discount factors reflecting the risk of default,
a premium for risk-bearing and a liquidity risk.

Our model of investor beha-

vior specifies the risk differential that an investor would require to compensate him for the first of these, the risk of default, given the probability of
default.
In his classical paper on bond risk premiums, Lawrence Fisher hypothesized
that the average risk premium depends first on the risk that the firm will

Both, Cornell University. The comments and suggestions of J. B. Silvers,


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

default on its bonds and second on the marketability of the bonds.

The three

variables chosen by Fisher as determinants of the risk of default were earnings


variability (as measured by the coefficient of variation of the firm's net income over the past nine years), financial leveraqe (as measured by the firm's
market value of equity to book value of debt ratio), and reliability in meeting
obligations (as measured by the length of time the firm has been operating without forcing creditors to take a loss).
Fisher defines the risk of default as the probability that the firm's
earnings will not be sufficient for the firm to meet the payments on its debts.
The variables noted above are those measurable variables he deems investors consider in estimating the aforementioned probability.

In the next section of

this paper we will present a graphical model of this interest rate setting process.

In the third section we will relate this process to the cost of debt

capital schedule and the debt capacity of a firm under some assumed investor
preferences.

We will conclude with some mathematical models that extend the

graphical process described earlier.

II.

The Risk of Default: A Graphical Analysis

The first objective of this section is to determine the size of the risk
differential on a bond necessary to give an investor an expected present value
equal to the present value he would earn if his funds were invested in a defaultfree security.

For simplicity let us assume that (1) the bond under discussion

is a perpetual bond and (2) the probability of the firm's survival (and consequently meeting its interest obligations) from one period to the next is p, independent of the length of time of survival.

Then the expected present value

of a bond that promises to pay annual interest of I dollars is the discounted


value of the expected interest payments, using the default-free interest rate i:

(1)

(2)

B - (ffj, [ i + (JB_,

2
Fisher, Lawrence. "Determinants of Risk Premiums on Corporate Bonds,"
The Journal of Political Economy (June 1959), pp. 217-237. Since the capital
asset pricing literature uses the term "risk premium" to describe the difference 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 later in the paper.
758

p
Since p, the probability of survival, is less than or equal to one, ^

< 1

and the sum of the infinite series in equation (2) converges so that equation
(2) can be written in closed form:

(3)

If this bond sells at par and pays a contractual rate r, I = rB, equation (3)
becomes

or, solving for the required contractual rate,

(4)

Thus, equation (4) specifies the contractual rate needed in order for the risky
bond to have the same expected present value as a default-free bond.

Note that

if the probability of survival is 1 (the interest payments are certain), equation (4) reduces to
1+i
r = -

.
1 = i;

the required rate is equal to the default-free rate of interest.


Equation (4) is sufficient to illustrate the type of process an expected
monetary value maximizing investor might employ.

Taking the partial derivative

of r with respect to p
dr
dp

-(1+i)
p2

we see that as the probability of survival increases, the investor-required


contractual interest rate decreases.

This relationship is depicted by the

curve labeled MM in Figure 1.


We next need to determine the relationship between the amount of interest
that has to be paid and the probability of survival. The firm's operations
(sales and operating leverage) result in earnings before interest and taxes
which are uncertain.

From the probability distribution of earnings one can

ascertain the probability of survival (probability of meeting interest payments)


4
Introducing risk-aversion behavior by the investor would intensify the
inverse relationship between the risk of survival and the investor-required
return.
759

Probability
of Survival

Required Contractual
Rate of Return

Figure 1
Investor Required Contractual Rate of Return

760

for all possible levels of interest payments. This is shown in quadrant III
of Figure 2, assuming the firm has no cash resources other than earned income.
Let us now turn to the options available to the firm issuing the debt.
Most important is the fact that, for a given level of outstanding debt, the
probability of survival is inversely related to the contractual interest rate
paid on the debt:

the larger the interest rate, the higher the promised annual

interest payments, and the lower the probability of survival.

The relationship

between the interest rate (r) and probability of survival (p) is depicted in
quadrant I of Figure 2.

To determine this relationship, let us choose an in-

terest rate, say r , on the horizontal axis of either Quadrant I or IV, and
o
trace clockwise around the four quadrants. The implied interest payment for
B

of debt is I and the corresponding probability of survival is p . Thus if

the firm has B par value dollars of debt outstanding and pays interest rate
r , the probability of survival is p . Quadrant II has a 45 line that enables
us to move from Quadrant III to I.

In Quadrant I the point (r , p ) is the


o

first point to be determined of an interest rate-survival probability feasibility curve QQ.

By successive tracings for varying interest rates, one can de-

velop the interest rate-survival probability set shown in. the first quadrant
of Figure 2 for B of debt.
Finally, Figure 3 shows how to combine the investor's required rate of
return set from Figure 1 (denoted MM) with the interest rate-survival probability feasible set from the first quadrant of Figure 2 (denoted QQ) to ascertain
r*, the minimum interest rate required by the market for B of debt.
The default-risk differential is (r* - i) and from equation (4)
r*

. i = iL _ ! . i
P*

where p* is taken from the equilibrium solution in Figure 3.


III.

Example

Suppose the probability distribution of earnings before interest and taxes


is uniform between $0 and $1000 and the firm wishes to sell $300 worth of bonds
at par.

If the default-free interest rate is 4 percent and investors behave

according to equation (4), what is the minimum acceptable equilibrium interest


rate and what is the default risk differential the company must pay?
The solution will be obtained algebraically.

From the above suppositions

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

1 -

Figure 2
The Interest Rate - Survival Probability Set

762

ir*

Figure 3
Equilibrium Interest Rate Determination

763

the following relationships follow:


I = 300 r

(quadrant IV)

I = 1000 - 1000 p
(a)

(quadrant III)

The investor requirement curve, MM, can be obtained directly from


equation (4):

(b)

The firm's tradeoff set, QQ, is obtained by solving the equations


I = 300 r and I = 1,000 - 1,000 p
for p in terms of r:

300 r = 1000 - 1000 p

or
(c)

p =

1000 - 300 r

= 1 - .3 r

, .
(00)

Taking the two equations from (a) and (b) above and solving simultaneously for r we find that the two roots are

r = (.058, 2.275)
so that, ignoring the higher root,

r* = 5.8%, and the risk differential = 5.8% - 4% = 1.8%.


The probability of survival is:

p* = 1 - .3 r* = 1 - .3(.O58) = 0.983.

IV. The Cost of Debt and Debt Capacity


The model presented in the preceding section can be used to determine both
the cost of debt capital schedule and the debt capacity for a given firm.

One

approach would be to solve repeatedly for r* as we systematically vary the debt


outstanding, B, to find the cost of debt schedule, r*(B).

As B increases, the

firm's survival probability feasibility curve 0.Q of Figure 3 shifts inward.


Hence for a given investor preference curve, MM, r*(B) will rise as B increases
until MM and QQ are tangent, and the corresponding B, denoted B' , is the
max

764

firm's debt capacity.


est rate r*(B

max

While the market is willing to hold B


debt at intermix

) , it will not purchase any more debt than B


because the firm
max

cannot meet the investors' return-probability requirements.


An equivalent method would be to place the investor preference schedule,
MM, in Quadrant I (see Figure 4).

Choosing a point on MM, say (r ,p ) , let us

move counterclockwise through Quadrant II and Quadrant III to determine the market interest payment (I ) that can be paid with probability p .
The point
o
o
(r ,1 ) in Quadrant IV is one point defining a feasible amount of interest for
o o
given investor preference and a given interest rate r . By starting in Quadrant I with different values of r and repeating the process, we obtain the
curve labeled iR which is the set of points (r, I) that the firm could offer
to the market via bond issues and the market would accept. For any given level
of debt the equilibrium promised interest rate is determined by the intersection of the debt curve and iR curve in Quadrant IV. Thus if B

debt is issued

9
it would have to carry a promised rate of r*(B ) . The firm's debt capacity is
o
equal to B
since a larger amount of debt will result in an interest requiremax
ment that is not feasible.
The cost of debt schedule is, of course, a necessary input into any capital structure (mix of debt and equity financing) decision.

Aside from provid-

ing such a schedule, the above analysis also sheds some light on the extent to
which the firm can substitute debt for. equity financing.

is not the maxi-

max
mum market value of the firm.

Implicit in the above model is the assumption

that any earnings over and above the required interest payment I are paid as
equity dividends.
Thus there is an expected dividend stream for any debt level B (including
B
) that will vary in value inversely with the debt level. While further
J
'
max
Referring to Figure 3, as B increases and QQ shifts inward, the relevant
intersection of QQ and MM slides down MM, so that r*(B) increases as B increases.
For a general discussion of corporate debt capacity see G. Donaldson,
Corporate Debt Capacity (Harvard University, 1961).
g

Richard Holman suggested this method of analysis.


9
Since r*(B ) < r , the firm will issue bonds at r*(B ) rather than r .
o
o
o
o
See footnote 5.

765

max

r*(B ) r*(B
)
o
max

Figure 4
The Cost of Debt and Debt Capacity

766

exploration of this facet of the problem is inappropriate here, a few comments


are in order:
(1)

If excess earnings are retained in order to assist in meeting future


obligations in periods when income is not sufficient to meet debt
payments, investors would revise upward the probability of survival
over time reflecting this "cushion" effect.

would correspondnicLX

ingly be increased.

We approach this complexity indirectly in the

next section by examining investor preference behavior when the probability of survival increases over time with successful operations
rather than, as previously assumed, remaining constant.
(2)

In discussing optimal capital structure considerations, many theorists


have discussed the virtually "all debt-financed firm."

Income limi-

tations and investor preferences will limit the amount of debt a firm
can issue but an equity residual may still remain and carry some market value as long as some probability of a dividend on stock remains.
(3)

While the above analysis assumes investor preferences are solely the
result of expected monetary value considerations, the methodology and
qualitative conclusions do not rely on that assumption.

Risk prefer-

ences can be incorporated into the investor's decision process and the
resultant MM curve would shift to the right.

The extent of the shift

would depend on the extent to which the investor is risk adverse and
on diversification possibilities (portfolio considerations) implicit
in the firm's income stream.
V. Relaxing the Survival Assumptions
In this section we shall change the assumptions of the model in two ways:
first we shall relax the assumption that the bond has infinite maturity by allowing a principal repayment with a probability measure attached; second, after
ascertaining the equilibrium interest rate assuming finite maturity, we shall
allow for the revision of probabilities of survival, conditional upon past survival and examine how this modification affects the equilibrium interest rate.
These two extensions of the previous model affect the market trade-off curve
MM above, making it a more realistic investor indifference locus.
Let p

denote the probability of surviving each period (and consequently

If the bondholders were risk averters, the MM curve in quadrant I of


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

meeting debt interest payments) while the debt is outstanding, p

denote the

probability of collecting the final interest payment and principal at maturity,


and N denote the length of time to maturity. The market price of the debt selling at par is B. Assuming investors make decisions on the basis of expected
monetary value, they will be indifferent between investing in a riskless security yielding the default-free rate i and this debt if the promised interest
rate on the debt, r, is such that
fc

(5)

B =

P?" 1 P,d+r)B

-* " +

Dividing both sides by B and rewriting equation (5) using known geometric sum
formulas,
H_1
N-l

^1

M_1

P,(l+r)
- 1

or
P. r

p"" 1 - (l+i)11"1
+

Solving (6) for r we find


[(1+i)" - p " p 2 l (px - 1 - i)
(7)

p?"1- d+i)""1] + P ? ~ V

Note that if we divide the numerator and denominator of equation (7) by (1+i)
we find

and

iLA

liro

N
which is our earlier equation (4). Equation (4), in fact, holds for a bond of
any length of maturity (N) if the probability of survival is constant over time.
If p..=p_=p equation (7) reduces to equation (4) as follows:

768

[(14-J)N - p N ] (p-l-i)

p)

(p-l-i)

- P N ] (p-l-i)

- p N ] (p-l-i)
N+l
.. .,N
- (l+l) p + p

- pN]

or
(4)

p - l - i
~

1 + i
- - p -

Thus, the risk differential is invariant with the life of the bond when investors maximize expected net monetary value and the probability of survival is a
constant over time.

The result that, when p

= p

= p, the risk differential

is invariant to change in the length of time to maturity is not intuitively obvious.

One explanation is that the risk differential does not change as maturity

changes since the change in the expected present value of the principal repayment is exactly offset by the change in the expected present value of the interest payments.
Suppose the maturity date is put off from N to N + M. Then the change
(loss) in the net expected present value of the principal repayment is
PN+MB

- 1]

while the change (gain) in the net expected present value of the interest pay
ment is

1+i

P - (1+i)

Equating these two differences we find that

rp
p - d+i)

- 1

or

(4)

as we anticipated.
769

Table 1 shows the risk differentials for different values of N, p

and

p_ for i = .05; these values were computed using equation (7) and defining the
difference between the contractual risky rate (r) and the riskless rate (i) as
the risk differential.

The table shows that when p

> p , as length of time

to maturity increases, the risk differential falls. Also, as p


a given p

decreases for

and maturity, the risk differential increases.

We now turn to an examination of the effect of revising the probability


of survival over time. As Fisher's empirical analysis suggests, a history of
past survival enhances the probability of future survival and consequent interest and/or principal collection.
While it is undoubtedly dangerous to claim that probabilities of survival
will always increase with length of survival, if earnings are retained in profitable years and invested in risk-decreasing investments, this will change the
prbbability of survival curve for a given amount of debt.

The proportion of

excess earnings retained, as well as the rate of return earned on their reinvestment and the nature of the investment, will determine the rate at which the
probabilities of survival are revised upward.
While numerous formulations of the probability revision process could be
developed, we will use a simple one that reflects the spirit of the procedure.
Let us assume the probability of surviving in period t is

w + t
O

has survived in all previous t-1 periods.

if the firm

If the bond sells at par and pays

interest r on par value, and if investors are using the expected present value
of the future promised payments discounted at the default-free rate i as the
basis of setting the market price, then:
_ _ N " 1 (W-t-t) I SI rB
t
t=il (S+t) 1 W! (1+i)

(W+N) ! SI B(l+r)
N
(Wl) (S+N) ! (1+i)

or
(8)

B = rBA + B(l+r)G

The calculations for all the tables in this section were performed by
David Downes.
We could also interpret the situation as one where we do not know the
probability of survival, make an estimate of the prior probability, and revise
the probability as new information is obtained.
770

l "

.999

.002

.001

.001

.001

.001

.001

.001

.001

10

20

30

00

.003

.001

.055

.001

.001

.055

.003

.002

.055

.055

.055

.004

.009

.020

l = .950

.055

.056

.056

.059

.068

.055

.056

.058

.066

.084

.055

.057

.060

.073

.105

P2=.95O P2=.900 P2=.8OO P2=.700

.003

.005

.010

P2=.999 P2=.99O P2=.95O P2=.9OO

Maturity (N)

Time to

TABLE 1
.05

l = .900

.117

.117

.117

.118

.123

.136

.117
.117
.117
.117

.117

.117
.117

.117

.120

.135

. .175

.119

.129

.155

p =.900 p = .800 p =.700 P2=.6OO

VALUES OF THE RISK DIFFERENTIAL FROM EQUATION (7) WHEN i =

. NI
A = J^

.
where

(W+t) 1 SI ., ..-t
._
, w , (1+D
and G =

(s+t)

(W+N) ! S! ..-N
, w , d+i) .

(S+N)

Solving equation (8) for r we have

Table 2 displays the risk differential required by investors implied by


equation (9) for i = .05 and selected values of N, W, and S.

There are three

aspects of the table we wish to highlight:


(i)

For any given initial probability of survival, denoted p

in Table

w+i
2, there are infinite numbers of W and S pairs such that rrr = p..
S+JL
J.
For any given p , the lower the value of W (or S, since S = W/p ) ,
the faster the rate of revision.

Hence, for any given p

in Table

2, the risk differentials for the lower W are lower than for higher
W's.
(ii)

The initial probability of survival, p , does not alone determine


the risk differential.

In comparing two situations, it is possible

that the one with the higher initial probability of collection has
higher risk differentials for some N if the probability of survival
revises slowly.
p

= .85 and p

For example, compare the values in the columns under


= 4/5 = .8 in Table 2 for N = 10. The p

a higher risk differential than the p

= .85 has

= .8 column since probability

of survival revises very slowly with W/S = 85/100.


(iii)

For any given W and S, the risk differential decreases with length
of time to maturity.

Earlier we found that when probabilities of

survival are held constant over time, the risk differential was invariant to length of time to maturity.

Here, the probability of the

principal being repaid is higher than with the earlier model when
maturity is lengthened since the probability of survival for each
period revises upward over time; also the expected interest payment
is higher for the same reason, so the risk differential falls in this
case.

772

TABLE 2
VALUES OF RISK DIFFERENTIAL FROM EQUATION (9)
WHEN i = .05

Time to

= .90

Pj_ = -85

= .80

= .67

W+l= 9

W+l= 90 ' W+l<= 85

W+l=4

W+l= 8

W+l=2

W+l=6

S+l=10

S+l=100

S+l=5

S+l=10

l-3

S+l=9

.111

.116

.184

.239

.250

.452

.495

.099

.115

.182

.199

.224

.352

.444

10

.088

.113

.179

.168

.203

.291

.411

20

.077

.111

.177

.146

.187

.252

.393

30

.073

.110

.176

.137

.181

.238

.389

Maturity (N)

VI.

S+l=100

Conclusions

The Fisher paper of 1959 laid a partial foundation for understanding risk
differentials.

This paper is an attempt to reinforce and extend Fisher by

specifying the process and variables that determine the risk differential assigned by the market to the debt of a given firm with a given capital structure.

Using the model developed in this paper we are able to determine the

cost of debt capital curve as well as the debt capacity limit for any given
firm.
Though this paper introduces a unique method of analyzing debt, it must
be classified as a first step.

Investors most likely use something more com-

plex than simple expected net present value as a decision criterion and factors
that affect the likelihood and size (in case of partial payment) of debt obligation payments cannot be neatly summarized into well-behaved probability series.

Thus such factors as risk aversion and portfolio effects must be consid-

ered in the modeling of investor behavior.

Furthermore, the characterization

of the survival process and how it changes over time must be enlarged upon in
order to better ascertain the cost and limit of debt for a firm.

773