Question

Risk premiums on corporate bonds are usually anticyclical; that is, they decrease during business cycle expansions and increase during recessions. Why is this so?

Short answer

The risk premium is anti-cyclical, rising during a recession and falling during an expansion.

Step-by-step solution

Introduction

Any country's economy experiences fluctuations in its economic activities throughout time, and these fluctuations, or upswings and downswings, are referred to as business cycles or growth and recession. During an expansion, the economy grows in real terms, whereas during a recession, the economy contracts.

To determine

During expansions, the risk premium falls, but during recessions, it increases.

Explanation

During a boom or expansion period in the economy, the risk premium is smaller; very few businesses will go bankrupt during this time. As a result, there are fewer risks of corporate bonds defaulting, lowering the risk premium.

During a recession, however, the risk premium is higher; a huge number of businesses will go bankrupt during this time. As a result, there is a greater danger of corporate bonds defaulting, raising the risk premium. As a result, the risk premium is anti-cyclical, rising during a downturn and falling during an expansion.