The purpose of this paper is to estimate the Baa corporate bond spread and identify its four determinants: a default risk premium, a tax premium, an illiquidity premium, and an excess risk premium. Especially important is the modeling of the default risk premium which is the product of the probability of default and one minus the recovery rate. Both these two parameters are assumed to be stochastic. But, since an analytical joint distribution for them is difficult to find, the paper resorts to Monte Carlo simulation.
Although the number of obligor names is limited in bond portfolios the paper argues that time diversification, which arises from holding a bond portfolio for the long run, can reduce substantially the uncertainty and the negative skew in mean bond returns. The paper finds that the Baa spread of 144 basis points can be decomposed into a tax premium of 39 basis points, an illiquidity premium of 4 basis points, a default risk premium of 41 basis points, leaving 60 basis points for the excess risk premium. The paper concludes by that there is little evidence for a bond spread puzzle.