In CFA LV III curriculum, I found:" Credit premiums tend to be especially generous at the short end of the curve. This may be due to “event risk,” in the sense that a default, no matter how unlikely,
could still cause a huge proportional loss but there is no way that the bond will pay more than the issuer promised"
Some one please help explain: Why “default risk cause a huge loss but bond will not pay more than the issuer promised” make short term- bond credit premium greater than long term-bond credit premium.
Thanks
On a short dated bond we don’t have much time to maturity, lets say less than a year = 6 months.
Maximum payments are limited to maybe 1 coupon and par value.
Default could still mean total loss.
We could get to a point a week before maturity where it is still uncertain if we will be paid back. Yields will be very high as uncerttainity is high and the need for the company to fix things is immenant.
Owning the bond is this state is like writing a put.
Your upside is limited to return of par but downside could be 100%.
The logic would be investors are using a higher discount rate for a problem that is immediately in front of them rather than a problem that is a long way off. - this is an aspect of human nature.
Thanh you a lot!