Newbie here. I should say upfront that I'm not a quant, just someone trying to broaden his knowledge of fixed income investing. I apologise in advance if I'm mangling some terminology.
Imagine a rational investor who's trying to select from a set of risky bonds, all of which have the same maturity date yet different credit qualities. My question is, is it possible to say in advance which bond will have the highest expected return if held to maturity ? Will it be the bond with the highest yield, the one with the lowest yield - or is it impossible to generalise ?
I know that riskier bonds have a higher YTM, reflecting their increased rate of default. But AIUI, the existence of this "default premium" doesn't necessarily influence the expected return from the bond. Yes, a poor quality bond will trade at a lower price but you have a smaller chance of receiving the promised cashflows. In a perfect world I'd expect the two effects to balance out, and I therefore wouldn't think there's a strong reason for a rational investor to prefer the highest-yielding bond over the lowest-yielding, or vice versa (?)
I have read that there's also a credit risk premium, which (AIUI) represents the extra compensation that risk-averse investors demand for the stress and uncertainty of holding a bond that may or may not default. It's not a direct function of default probabilities or anything like that; it's purely a psychological/market-driven phenomenon (I've read papers debating whether this risk premium actually exists, but let's assume for a sec that it does)
Putting this all together, I think the rational approach is to select the bond that has the highest credit risk premium (CRP). The size of the default premium by itself isn't directly relevant (except in the sense that you need it in order to back out the CRP). This leads me to the conclusion that there is no easy way to choose between the bonds merely by looking at them.
Is my thinking basically correct here, or am I hopelessly mixed up ? thanks !