Question

1. Suppose Bond A has higher default risk than Bond B. Which bond should have the higher interest rate? Why?

2. Currently a number of industries are facing higher risk of default on bonds due to underperformance from COVID-19. Suppose the government announces next day that it will guarantee all corporate bonds and pay the creditors if the companies fail to do so in the future. Explain the mechanism how the government guarantee will affect the default risks, demands, prices, and interest rates of corporate bonds?

Answer 1

1. If Bond A has higher default risk than bond B then Bond A will offer highe interest rate this is because Bond holders wants to be compensated for thr risk that they will bear by holding a high risky asset.

2. Due to present situation of covid 19 if government declared that it will gurantee the corporate bonds then it will result in less risk premium, less spread due to no default and credit risk, which increases the demand for such bonds and prices shoots up for such bonds and therby lowering the interest rate.