Question

13.

Issuer	Rating	Yield	Spread	Treasury Benchmark
Corporation A	Triple A	7.87%	50	10
Corporation B	Double A	7.77%	40	10
Corporation C	Triple A	8.60%	72	30
Corporation D	Double A	8.66%	78	30
Corporation E	Triple B	9.43%	155	30

a. What is meant by rating?

b. Which of the five bonds has the greatest credit risk?

c. What is meant by spread?

d. What is meant by Treasury benchmark?

e. Why does each spread reported reflect a risk premium?

14. For the corporate bond issues reported in the previous question, answer the following questions:

a. Should a triple-A-rated bond issue offer a higher or lower yield than a double-Arated bond issue of the same maturity? b. What is the spread between the corporation A's issue and corporation B's?

c. Is the spread reported in part (b) consistent with your answer to part (a)?

d. The yield spread between these two bond issues reflects more than just credit risk. What other factors would the spread reflect?

e. Corporation B's issue is not callable. However, corporation A's issue is callable. How does this information help you in understanding the spread between these two issues?

Answer 1

13 a) Rating is assigned to bonds considering the credit risk it holds. If a bond is very secured, say senior bonds where company is ready to pay the bondholders first in case of liquidation, then that bond class will have a higher rating compared to other classes. The more secured a bond is, the greater rating it will get.

Ratings are being assigned by rating agencies, who does thorough analysis of the bonds before giving ratings.

b) Bond Issued by corporation E has the greatest credit risk as its rating is the lowest. Bond ratings start from Triple A being the highest to double A, then A, then Triple B and so on till junk bonds. As rest of the corporations are in A category and only Corporation E is in B category, so its credit risk is the highest.

c) Spread refers to the difference in Interest Rate offered by the bonds issued by corporations as compared to a benchmark. Benchmark can be treasury bonds, Swap rate, Risk Free rate etc. So if a bond issue is riskier as compared to a benchmark, then its spread will increase, because it will have tro provide higher interest rate to make people invest in them.