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A debt portfolio with an average yield of 10%, a default rate of 5%, and a recovery rate of 50% is mathematically identical to a risk-free asset with a yield of 7.5%. The problem is, defaults are unpredictable and therefore demand a risk premium.

A JTS of 3% leaves little room for further narrowing of the spread - it’s much more likely to rise, which will result in price fall and further erosion of return. Contrariwise, a JTS of 9% is quite likely to narrow, resulting in price gain.

To explain our model, below we’ve plotted the JTS versus the forward five-year difference in returns between junk and treasuries: -

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* Contributed by -
Ankit Chetan & Sudhanshu Duggal,
National Institute of Industrial Engineering (NITIE),
Mumbai.