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

An investment grade is a rating that signifies a municipal or corporate bond presents a relatively low risk of default. Bond rating firms like Standard & Poor’s and Moody's use different designations, consisting of the upper- and lower-case letters "A" and "B," to identify a bond's credit quality rating.

"AAA" and "AA" (high credit quality) and "A" and "BBB" (medium credit quality) are considered investment grade. Credit ratings for bonds below these designations ("BB," "B," "CCC," etc.) are considered low credit quality, and are commonly referred to as "junk bonds."

To entice investors and to compensate them for the attendant risks, issuers with lower-rated credits must pay a higher rate of interest than companies whose bonds are given an investment-grade rating. This in turn generates a higher “yield” for investors. For example, suppose a company that qualifies for the highest rating (AAA/AA-) issues a 10-year bond with a yield of 6%. To compete for capital, a company rated single-B (or BBB+) may need to offer a yield of 9% to 11%.

Hence, the above situation where ABC is a BBB+ (low credit rating) rated company whose bonds have a 10-year maturity and trade at 5.0% yield and XYZ is an AA- (high credit rating) rated company whose bonds also have a 10-year maturity and trade at a 5.5% yield is not possible as there is “no free lunch”.