Question

Indicate which bond in the following pairs of bonds is likely to bear the higher interest rate (yield) and state why. If there is no general reason for a difference, indicate that they would be the same.

a. A corporate bond rated Aaa or a municipal bond rated Aaa

b. a municipal bond rated Baa or a municipal bond rate Aa

c. A general obligation bond issued by a city or a revenue bond issued by a city

d. a general obligation bond rate Aa issued by a city or a general obligation bond rated Aa issue by a county

e. A municipal bond (term) with maturity in five years or a municipal bond (term) with maturity in 20 years

Answer 1

Bonds with higher risk have higher yields because investors require higher yields to compensate them for the additional risk.

a]

A corporate bond will have a higher yield because corporate bonds in general are more risky than municipal bonds. Municipal bonds are issued by local governments, cities or states, and are backed by the government of those local governments, cities or states. Hence, they have low risk.

b]

A bond rated Baa will have higher yield because Baa is a lower credit rating than Aa. Lower credit rating means higher risk.

c]

Revenue bonds will have higher yields because they are more risky than general obligation bonds. Revenue bonds are issued for a specific project, unlike general obligation bonds which are not specific. Hence, general obligation bonds have lower default risk because the issuer can raise taxes to fund the bond payments, whereas this is not possible for revenue bonds.

d]

A general obligation bond rated Aa issue by a county will have a higher yield because it is more risky than a general obligation bond rated Aa issue by a city. This is because a city will have higher revenues and taxes than a county, and hence the default risk on a city bond is lower.