Question

Which of the following statements is CORRECT?

1.

The yield on a 3-year Treasury bond cannot exceed the yield on a 10‑year Treasury bond.

2.

The yield on a 2-year corporate bond should always exceed the yield on a 2-year Treasury bond.

3.

The yield on a 3-year corporate bond should always exceed the yield on a 2-year corporate bond.

4.

The yield on a 10-year AAA-rated corporate bond should always exceed the yield on a 5-year AAA-rated corporate bond.

5.

The following represents a “possibly reasonable” formula for the maturity risk premium on bonds: MRP = -0.1%(t), where t is the years to maturity.

Answer 1

The answer is option 2 of the given set ie., 'The yield on a 2-year corporate bond should always exceed the yield on a 2-year Treasury bond.' because, corporate bonds will have risk premium as part of their yield which is over and above the risk free rate of return. Since the yield on 2 year Treasury bond represents risk free rate of return for 2 year, yield on corporate bond of identical maturity should always exceed the former.

Other options:

Option 1: Not correct, since the the yield on 3 year treasury bond can exceed 10 year treasury bond in case the yield curve slopes downwards (inverted bond yields)

Option 3: Not correct. Corporate bond yields are dependent on risk perceptions on the issuer along with the term structure of interest rate (yield curve).

Option 4: Not correct. Even if the risk is identical (as reflected in the rating), term structure can cause difference in yield. In such cases, If the yield curve is flat or downward slopping, the bond of longer duration will not yield higher returns.

Option 5: Not correct. Maturity risk premium is the compensation for longer term to maturity and increases according to the increase in term to maturity. The formula given will result in decreasing maturity risk  premium on increase in years to maturity.