Cost of Debt: YTM vs Expected Yield

Bond Inputs

Face Value ($)

Coupon Rate (%)

Years to Maturity

Promised Yield / YTM (%)

Or adjust price slider below to calculate YTM

Market Price (as % of Face) 98.5

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Default Probability per Year (%)

2.0%

Recovery Rate (% of Face) 40

Risk-Free Rate (%) 3.0

Key Metrics

Promised Yield (YTM) 7.00%

Expected Yield (Accounting for Default) 6.64%

The Overstatement 0.36%

                    Key Insight: Using YTM in WACC overstates the true cost of debt by 5.1% for this firm.
                

Credit Spread Decomposition

Risk-Free Rate 3.00%

Expected Loss Component 1.20%

Risk Premium Component 2.80%

Total Credit Spread 4.00%

Understanding the spread:
The credit spread (YTM -- risk-free rate) has two components. The expected loss component compensates investors for actual default losses. The risk premium compensates for the risk/variance of returns. Only the risk-free rate and expected loss matter for WACC; the risk premium is diversifiable.

Typical Default Rates by Credit Rating

These default rates are historical averages. Impact on cost of debt depends on recovery rate and maturity.

Rating	Default Prob (Annual)	Promised Yield	Expected Yield	Overstatement

Cost of Debt: Why YTM Overstates the True Cost

Bond Inputs

Key Metrics

Credit Spread Decomposition

Expected vs Promised Yield by Default Probability

Credit Spread Decomposition

Typical Default Rates by Credit Rating