Question

ABC is a BBB+ rated company whose bonds have a 10-year maturity and trade at 5.0% yield.

XYZ is an AA- rated company whose bonds also have a 10-year maturity and trade at a 5.5% yield.

Apply the concept of “no free lunch” to explain if this situation is possible.

Answer 1

No free lunches mean that investors will not invest in a riskier company unless it gives a higher rate of return. In the above question, ABC has rating BBB+ over XYZ having AA- rating. It means that ABC is safer than XYZ. Therefore, unless XYZ provides more yield, investors will not invest in XYZ.

Therefore, company XYZ is giving more yield at 5.5% as compared to ABC.

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