Question

Bonds X and Y are very similar: they have the same face value, the same coupon rate, the same maturity, and both make semi-annual payments.  Bond X has a credit-rating of AA.  Bond Y has a credit rating of BB.  Which bond will have the higher yield to maturity?  Why?

Answer 1

Bond Y with credit rating BB will have higher yield to maturity.

There exists an inverse relationship between credit rating of bond and its yield to maturity. This means

• When credit ratings are high, yield to maturity will be low.
• When credit ratings are low, yield to maturity will be high.

To understand this we need to acknowledge that risk and return goes hand in hand. Which means an investor willing to take more risk will be rewarded with higher returns and vice-versa.

Similarly bonds with higher credit ratings means that there is a low risk of default in such bonds and thus offer lower yields. Bonds with low credit ratings are risky and thus the investor will want more yield for making investment in such bonds. Thus bonds with lower credit rating will involve greater risk and thus it will have higher yield to maturity.

Bond with credit rating of AA will have lower risk.

Bond with credit rating of BB will have higher risk.