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Answer: Bond investors are being compensated for their exposure to systematic risk.
## Explanation **A is correct.** The persistent positive difference between credit spread returns and loss rates (ranging from 0.7% to 1.3% annually) indicates that corporate bond investors are receiving compensation beyond just expected default losses. **Key reasons:** - **Systematic risk exposure:** Default risk in corporate bonds cannot be fully diversified away, as defaults tend to cluster during economic downturns (systematic risk) - **Risk premium:** Investors require additional compensation for bearing this undiversifiable systematic risk - **Default correlation:** If defaults were truly independent, the gap between credit spreads and actual loss rates would be much smaller **Why other options are incorrect:** - **B:** Credit spreads are determined by market forces, not specifically set by market makers to exceed loss rates - **C:** Corporate bonds actually have LESS liquidity than risk-free sovereign debt, and lower liquidity typically requires higher returns, not explains the persistent gap - **D:** While credit spreads and interest rates may have some correlation, this doesn't explain the systematic relationship between credit spreads and loss rates The persistent positive gap represents the systematic risk premium that compensates investors for the possibility of correlated defaults during economic stress periods.
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A quantitative analyst is preparing a performance report of a corporate bond portfolio. For the previous 1-year period, the analyst finds that the return on the portfolio was 4.4% and decomposes this return as follows:
When observing the portfolio's returns over a 3-year period, the analyst notes that the difference between the portfolio's return attributable to the credit spread and its loss rate remained positive and varied from 0.7% to 1.3% each year. Which of the following would the analyst be correct to identify as the most likely explanation for the persistent positive difference between the credit spread and the loss rate?
A
Bond investors are being compensated for their exposure to systematic risk.
B
Credit spreads are specifically set by market makers to be greater than loss rates.
C
Corporate bonds have more liquidity than risk-free sovereign debt.
D
Credit spreads tend to be negatively correlated with interest rates.