Consider two different bonds: one riskless, and the other risky. Suppose the risky bond has a known probability of default. Suppose a market is made in these bonds, with investors trying to maximize return.
In fact, let's consider a specific scenario in which a riskless 1 year, $1,000 bond will return 5% in one year. Suppose a risky $1,000 bond will default (no interest, plus loss of principal) with probability .01. In this case, if the interest rate on the risky bond is 6.060606...%, then (speaking in simple terms), the bond will return $1060.060606... after one year 99 times out of 100, and $0 one time out of 100, for an average return of (99*1060.060606...+0*1060)/100=1050. In other words, a risk premium of .010606060... above and beyond the risk free rate .05 is enough to compensate for the .01 probability of default.
Assume we have a market with the two bonds described above. Assume it is perfectly efficient. If the risky bond sells for a rate higher than .060606..., there would be excess returns possible, and participants could buy down the interest rate to .060606..., at which point it matches the risk-adjusted return of the risk-free rate.
In this case, the risk premium of .01060606... is only enough to compensate for default risk. When investors buy the bond at this price, they are essentially buying a "risk free" bond, assuming they repeat this scenario indefinitely and can absorb the occasional loss over time.
My question is: in a perfectly efficient market, are all bonds priced in such a way so that they all return the same amount (on average), after accounting for risk? In other words, do risk premiums only compensate for the amount investors might lose?
Another way of saying it: In a perfectly efficient market, would all bond portfolios have an average return (after averaging out all defaults) equal to the risk free rate of return?