Question

A 5 year AA rated corporate bond has a nominal yield spread over a 5 year Treasury of 50 basis points. A 7 year BBB corporate bond has a nominal yield spread over the same treasury of 1.50%. Neither corporate bond has any embedded options. Please identify the risks that may explain the difference in the yield spreads of the AA and BBB bonds?

Answer 1

Some of the major risks that long term bonds hold over short term bonds are

a) Interest rate risk

There is higher probability for a long term bond to show higher interest rates and thus negatively affecting the pricing of these bonds. As a result an investor who purchases these bonds will find these bonds at much depressed prices compared to when they bought it.

b) Duration and Convexity

Long term bonds have greater duration and higher convexity than short term bonds. Due to this, a given interest rate change would have greater effect on long term bonds than short term bonds.