Question

4. The following is the YTM of five 30 year, 8% coupon, 1000 par value bonds:

BOND / TYPE	S&P Ratings	Yield to Maturity
1 / US Govt	AAA	8.00
2 / Corporate	AAA	Not Available
3 / Corporate	B	9.00
4 / Corporate	CC	Not Available
5 / Corporate	D	10.00

a. Your boss asks you which to give him a range of possible YTM's for the No 2 and the No 4 bond. What would be your best guess? Fill it in.

b. Calculate the default premium of the No 5 bond. Is it expected to increase, decrease, or remain unchanged, during the next recession [Note: default premium is (risky interest rate - risk-free interest rate)]

Answer 1

a.

Lower ratings are accompanied with higher yields. This is because ratings are a reflection of risk. Higher is the perceived risk, lower is the rating and therefore higher is the expected return to compensate for that risk.

Since, Bond 2 lies between AAA government security (8% yield) and a B rated corporate bond (9% yield), its yield must lie between 8% - 9%

Similarly, Bond 4 must have a yield between 9% and 10%.

b.

Default premium on a security is equal to the yield on that security minus the risk free rate. Risk free rate can be taken as 8% because government securities can be considered risk free. So, default premium on no 5 bond is:

= 10% - 8% = 2%

During a recession, this figure can be expected to increase because recession increases the chances of this firm defaulting on its interest payments, which increases risk and therefore increases the expected return.