Ibbotson’s “Stocks, Bonds, Bills and Inflation” data set is widely used because it provides monthly US financial data series going back to as early as 1926. In this data set, 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 paper we show that this default premium is seriously flawed in two ways: (1) it is not based on subtracting maturity-matched government bonds from corporate bonds, and therefore contaminated with a considerable interest rate component, and (2) 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.
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