8. Bond ratings Aa Aa Rating agencies-such as Standard & Poor\'s (S&P;), Moody\'

Question

8. Bond ratings Aa Aa Rating agencies-such as Standard & Poor's (S&P;), Moody's Investor Service, and Fitch Ratings-assign credit ratings to bonds based on both quantitative and qualitative factors. These ratings are considered indicators of the issuer's default risk, which impacts the bond's interest rate and the issuer's cost of debt capital Based on these ratings, bonds are classified into investment-grade bonds and junk bonds. Which of the following bonds is likely to be classified as a junk bond? A bond with a BBB rating, a 14% return on capital, a 42% total debt to total capital, and a 10% yield. A bond with a B rating, an 11% return on capital, a 87% total debt to total capital, and a 26% yield. You heard that rating agencies have upgraded a bond's rating. The yield on the bond is likely to increase the bond's price will _decrease and Assume you make the following investments . A $10,000 investment in a 10-year T-bond that yields 5.50%, and . A $20,000 investment in a 10-year corporate bond with an Baa rating and a yield of 8.80% Based on this information, and the knowledge that the difference in liquidity risk premiums between the two bonds is 0.30%, what is your estimate of the corporate bond's default risk premium? ? 3.30% ? 3.00% ? 5.10% 4.20%

Explanation / Answer

Solution 1:

Based on these ratings, bonds are classified into investment-grade bonds and junk bonds. Which of the following bonds is lively to be classified as a junk bond?

Correct option:

A bond with a B rating, an 11% return on capital, a 87% total debt to total capital, and a 26% yield.

Reason: A, B-rated bond with high debt to capital ratio and higher yield is considered to be junk bond.

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Solution 2:

You heard that rating agencies have upgraded a bond's rating. The yield on the bond is likely to Decrease, and the bond's price will Increase

Reason: As bond is upgraded by rating agencies the yield decreases due to high quality of bond. High quality bond pays lesser yield. As yield is low the price of bond increases because of lower discounting factor for the bond.

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Solution 3:

Correct option is 3.00% (2nd option)

Working:

Default risk premium = Corporate bond yield - Liquidity risk premium - T-Bond yield

Default risk premium = 8.8% - 0.3% - 5.5% = 3%

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