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

In finance, one of the most important concept is the concept of risk return trade off. Investors will have to rewarded for every unit of risk taken in the form of higher expected return. That is there is no free lunch for investing in a lower grade security. Any investment must come with higher expected return or yield in the bond market jargon. As per rating scale, a AA- rated bond is higher than a BBB+ rated bond and for a similar maturity profile, BBB+ rated bond must be yielding higher than the AA- rated bond as per the risk return trade off. Hence this situation where the AA- rated bond yielding 5% less than the 5.5% yielding by the BBB+ rated bond is not possible.