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. (10 points)

Answer 1

The concept of no free lunch means nothing in life is free as we say no pain no gain. There is an implicit cost attached which is being paid by somebody if we get anything for free. So if we get anything free then there must be an opportunity cost attached which is not taken into account.

In this case, we can see two bonds of the same maturity have different yields that are due to the risk-factor difference between the two companies which are reflected in their rating. The BBB+ rated bond has less risk associated with its future cashflows than the AA- bond, Which has caused a lesser yield for BBB+ bond.

If someone thinks that he can receive a higher return by investing in an AA- bond then he is not taking into account the risk he will be taking. He is being rewarded for the additional risk he has taken so it is not what he is getting for free.

Again the person who is investing at 5% is having an opportunity loss of 0.5% by not investing in AA- bond. So he is reducing the risk of his investment by paying 0.5% which is his opportunity cost. Hence he also doesn't get anything for free.

The company that is paying more to raise funds i.e. the AA-rated company it is because of credibility issues. So he is not paying more for free but for the riskiness of future cashflow and probability of default.