Suppose currently 10-year Treasury note offers 2.8% yield and the average yield on investment grade 10-year...

Suppose currently 10-year Treasury note offers 2.8% yield and the average yield on investment grade 10-year corporate bonds is 4.4%. Calculate the risk spread. Predict what will happen to the yields of corporate and treasury bonds as well as the risk spread if the federal government guarantees today that it will pay to bondholders if the corporations go bankrupt in the future.

Solutions

Expert Solution

Risk spread = Yield on Corporate bond - Yield on Treasury note

Risk spread = 4.4% - 2.8% = 1.6%

If the federal government guarantees today that it will pay to bondholders if the corporations go bankrupt in the future,

1) Risk spread reduces close to 0% as the credit risk on corporate bond becomes equal to that of US govt's T notes

2) Corporate bond yields will reduce as the default risk greatly reduces

3) Now that the US government bears the default risk of these private corporates, the sovereign default risk increases little, and hence, its T note yield increases marginally.

Rahul Sunny answered 1 year ago

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