Question

7. Bond ratings Rating agencies such as Standard & Poor's (S&P), MoodyInvestor 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 nome e anche classified Based on these ratings, bonds are classified into investment-grade bonds and junk bonds. Which of the following bonds is kely to be investment-grade bond? A bond with 30% return on capital, total debt to tota O A bond with 10% return on capital, total debt to tota You heard that rating agencies have downgraded a bond Assume you make the fonowing westerno ssume you make the fol A $10.000 investment in a 10-year T-bond that yield of 13.50% • A $20,000 investment in a 10-year corporate bond with an Baal rating and a yield of 17.55% 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? 0 3.654 01.02 05.11 5.089

Answer 1

Investment grade bonds have high return on capital , low debt to capital ratio and low yield .

So, the bond with 30% return on capital, total debt to total capital of 15% and 6% yield is likely to be classified as an Investment grade bond

When a bond's rating is downgraded, it becomes more risky, investors demand more return from it thereby decreasing its price which increases its yield

The yield on the bond is likely to increase and the bond's price will decrease

Total risk premium of corporate bond over T bond = 17.55% -13.50% = 4.05%

As the difference in liquidity risk premium is 0.40% , the rest of the total risk premium is due to the default probability of the corporate bond

So, Corporate bond's default risk premium =4.05% -0.40% = 3.65%