Question

A five-year government bond is being issued with a 3.8% coupon rate, while a fiveyear corporate bond with an AA rating from Standard and Poor's is being issued with an 4.5% coupon rate, both paid semi-annually. The corporate bond has an embedded call option. Explain the reason or reasons for the differences in the coupon rate.

Answer 1

The reasons for the differences in the coupon rate are:

• The government bond is nearly default free bond while the corporate bond, even though has AA rating, has some finite probability of default. Hence, the compensation desired by the bond holder contains some default risk premium built in the coupon. Hence, the coupon rate is higher in case of corporate bond.
• The corporate bond has an embedded call option. This gives the issuer a right to call the bonds in case of declining interest rate, before maturity. The bondholders are at a relatively disadvantageous position because they have higher reinvestment risk. Hence, the coupon reflects some premium on account of this risk. Hence, the coupon rate is higher.