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Ibbotson’s default premium: Risky data

Ibbotson’s default premium: Risky data

14-06-2013 | Research
The default premium calculated in Ibbotson’s dataset is widely used in empirical research. However, this default premium is seriously flawed.
  • Patrick  Houweling
    Patrick
    Houweling
    Head of Quant Credits
  • Winfried  Hallerbach
    Winfried
    Hallerbach
    Researcher

Speed read

  • Ibbotson’s default premium is widely used in research
  • But this default premium is flawed in two ways
  • These biases seriously limit the use of this default premium
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Ibbotson’s Stocks, Bonds, Bills and Inflation dataset is widely used because it provides monthly US financial data series going back to as early as 1926. In this dataset, the “default premium” is calculated as the difference between the total returns on long-term corporate bonds and long-term government bonds. This excess return is used in empirical research to represent the compensation for default risk exposure.

In this article,1 we show that this default premium is seriously flawed in two ways. First, it is not based on subtracting maturity-matched government bonds from corporate bonds, and therefore is contaminated with a considerable interest rate component. Second, it is based on very high-quality corporate bonds and hence rather insensitive to market-wide changes in default risk. These maturity and quality biases seriously limit the use of the Ibbotson default premium series in empirical research, because instead of reflecting pure default risk, it also (negatively) reflects interest rate risk.

1 Hallerbach, W. G. and Houweling, P., 2013, ‘Ibbotson’s Default Premium: Risky Data’, The Journal of Investing.

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