Question

10. 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? OA bond with a BBB rating, a 14% return on capital, a 42 % total debt to total capital, and a 10 % yield. OA 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 downgraded a bond's rating. The yield on the bond is likelly to and the bond's price will 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 A rating and a yield of 7.20 % Based on this information, and the knowledge that the difference in liquidity risk premiums between the two bonds is 0.40% , what is your estimate of the corporate bond's default risk premium? 1.30% 2.21% O 1.82% O 1.70%

Answer 1

1) In the given question, based on the credit ratings, the bond to be classified as a Junk bond is a bond with B rating.

Bonds can be investment grade and junk grade bonds based on the rating. BBB bonds are medium risk bonds and B bonds are high risk bonds. A junk bond is a high risk bond with higher yields as compared to investment grade corporate bonds. Hence in the given question, the bond with B rating and 26% yield is the Junk bond

2) On downgrading a bonds rating: The yield on the bond is likely to INCREASE and the bond's price will DECREASE.

In case of downgrading, it means the chances of default in payment (credit risk) is higher. as a result of higher credit risk, the investors require higher return from the bonds. As a result the yield will increase. The relationship between yield and price is inverse. Hence the bond price will fall.

3) Based on the given details:

Default Risk premium of Corporate Bond= Annualised percentage Yield - Risk free Rate - Liquidity Risk premium

= 7.2% - 5.5%-0.4% = 1.30 %