1. Consider the following four debt securities, which are identical in every cha
ID: 1248408 • Letter: 1
Question
1. Consider the following four debt securities, which are identical in every characteristic except as noted:
W: A corporate bond rated AAA
X: A corporate bond rate BBB
Y: A corporate bond rated AAA with a shorter time to maturity than bonds W and X
Z: A corporate bond rated AAA with the same time to maturity as bond Y that trades in a more liquid market than bonds W, X, or Y
List the bonds in the most likely order of the interest rates (yields to maturity) of the bonds from highest to lowest. Explain your work.
Explanation / Answer
x, w, y, z from highest yield to lowest yield. YTM is a function of risk and time to maturity. As time to maturity increases, the required yield must increase as well. As risk increases, the YTM must increase too. As Z has a short maturity, in a more liquid market, and is AAA rated, it will be the least risky, and thus have the lowest yield. y would be next highest, as it has a short maturity, but is in a less liquid environment, which means it must have a higher yield to compensate for liquidity issues. W is next highest because although it is AAA rated, it has a longer maturity than Z or Y. As such it must have a higher return to compensate the bond holders. X must have the highest as it is BBB rated and is the most risk of the bonds. with the same maturity as W
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