Rating agencies-such as Standard & Poor\'s (S&P;), Moody\'s Investor Service, an
ID: 1171628 • Letter: R
Question
Rating agencies-such as Standard & Poor's (S&P;), Moody's Investor Service, and Fitch Ratings-assign credit ratings to bonds based on both quantitative and qualitative factors. These ratings are considered indicators of the issuer's default risk, which impacts the bond's interest rate and the issuer's cost of debt capital. Based on these ratings, bonds are classified into investment-grade bonds and junk bonds. Which of the following bonds is likely to be classified as an investment-grade bond? O A bond whose issuer has a 30% return on capital, a total debt to total capital ratio of 15%, and a 6% yield. O A bond whose issuer has a 10% return on capital, a total debt to total capital ratio of 85%, and a 13% yield. You heard that rating agencies have upgraded a bond's rating. The yield on the bond is likely to the bond's price will and Assume you make the following investments A $10,000 investment in a 10-year T-bond that yields 10.00%, and . A $20,000 investment in a 10-year corporate bond with an AA rating and a yield of 11.20% Based on this information, and the knowledge that the difference in liquidity risk premiums between the two bonds is 0.50%, what is your estimate of the corporate bond's default risk premium? 0 0.98% ? 1.20% ? 0.70% ? 1.19%Explanation / Answer
QUESTION 1
Investment grade bonds generally are those, which carry lower risk of default and lower risk ultimately leads to lower yield on these bonds. For the bonds given in question, first bond has higher ROC, lower leverage which define low risk and correspondingly low yield signify lower return - which is congruent to our financial theory of lower risk demand lower returns. So investment grade bond is bond 1.
QUESTION 2
When the rating on the bond is upgraded, its probability of default is basically less. This reduced its default risk. In finance terms, we know lower risk comes with lower returns. Since the risk reduces when default probability is lower, the yield on the bond declines. Increase in the yield basically leads to increase in bond price.
We also know there is an inverse function between the price of bond and its yield. When the yield declines, bond prices increase and vice-versa.
QUESTION 3
Spread between the yield of the 2 bonds reflect the risk.
In this question,
Spread between AA-bond and T-bond = Default risk premium + Liquidity risk premium
Spread between AA-bond and T-bond = 11.20% - 10% = 1.20%
1.20% = Default risk premium + 0.50%
Default risk premium = 0.70%
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