Question

​(Cost of​ debt)  Tellington Inc. recently discussed issuing a 7​-year-maturity bond issue with the​ firm's investment banker. The firm was advised that it would have to pay 3.00 to 4.00 percent on the bonds. Using information in the popup​ window, LOADING...​, what does this rate suggest to you about the​ firm's default​ rating?

Corporate Bond​ Yields: Default Ratings and Term to Maturity
Rating	1 yr	2 yr	3 yr	5 yr	7 yr	10 yr	30 yr
​Aaa/AAA	0.22	0.31	0.42	0.76	1.26	2.00	3.41
​Aa1/AA+	0.26	0.43	0.58	0.96	1.46	2.17	3.62
​Aa2/AA	0.29	0.55	0.74	1.16	1.66	2.35	3.83
​Aa3/AAminus−	0.31	0.58	0.77	1.20	1.70	2.39	3.88
​A1/A+	0.32	0.60	0.80	1.23	1.73	2.43	3.93
​A2/A	0.55	0.80	0.98	1.40	1.89	2.57	4.03
​A3/Aminus−	0.62	0.95	1.18	1.66	2.19	2.92	4.51
​Baa1/BBB+	0.83	1.19	1.42	1.91	2.45	3.18	4.80
​Baa2/BBB	1.00	1.39	1.65	2.17	2.73	3.48	5.17
​Baa3/BBBminus−	1.49	1.87	2.11	2.62	3.16	3.91	5.56
​Ba1/BB+	2.27	2.64	2.90	3.41	3.98	4.75	6.37
​Ba2/BB	3.04	3.41	3.68	4.21	4.79	5.58	7.19
​Ba3/BBminus−	3.82	4.18	4.47	5.00	5.61	6.42	8.00
​B1/B+	4.60	4.95	5.25	5.79	6.42	7.26	8.82
​B2/B	5.38	5.72	6.04	6.59	7.24	8.10	9.63
​B3/Bminus−	6.15	6.49	6.82	7.38	8.06	8.93	10.45
​Caa/CCC+	6.93	7.26	7.61	8.17	8.87	9.77	11.26
U.S. Treasury Yield	0.18	0.25	0.32	0.60	1.00	1.59	2.76

The​ firm's default rating is estimated to be about  ​(Select the best choice​ below.)

A.

Ba 3 /BB minus or B 1 / B +

B.

Aa 2 / AA or Aa 3 / AA -

C.

A 3 / A -or Baa 1 / BBB +

D.

Baa 3 /BBB - or Ba 1 / BB +

Answer 1

Baa 3 /BBB - or Ba 1 / BB + (which is Option D)

_____

Explanation:

Based on the information provided in the question, we can see that the yield to maturity of 3% to 4% for a 7 year bond falls between the rating Baa3/BBB− (YTM = 3.16%) and Ba1/BB+ (YTM = 3.98%). As Tellington Inc. is planning to issue a 7 year maturity bond on which it will have to pay/offer 3% to 4% interest, the bond is likely to get assigned a rating of either Baa3/BBB− or Ba 1 / BB +. Therefore, Option D is correct.