1.

What is the relationship between a corporate bond rating and a risk

premium?

In investment, a corporate bond rating represents the creditworthiness of the corporate bond. The
ratings are published by credit rating agencies and used by investment professionals to assess the
likelihood the debt will be repaid. Generally, the lower the corporate bond rating, the higher the
likelihood of default and thus, the higher the bond’s yield. Risk premium is defined as the return
in excess of the risk-free rate of return that an investment is expected to yield. An asset’s risk
premium is a form of compensation for investors to tolerate the extra risk compared to that of a
risk-free investment. Lower corporate bond ratings mean that the yield of the corporate bonds
will be higher and causes the risk premium to increase.

2. What is default risk and risk premium? How can default risk
influence interest rates?
Default risk occurs when an issuer of security or a borrower is unable to
precede interest and face value payments. There are certain default-free
bonds or government Treasury bonds, which never fail in repaying debt
(governments may increase taxes to repay its debt). The Spread between
the interest rates on bonds with default risk and default-free bonds is risk
premium. So bonds with default risk always have a positive risk premium;
thus, higher the default risk higher is the interest rates on the securities.

3. “Corporate bonds and stocks are a bad combination of investments

as both have different characteristics that do not complement each
other.” Discuss.

Corporate bonds and stocks can be a good or bad combination based on the timing of the investment
concerned. During times of increasing interest rates, the bond value will go down. So, it is better
to purchase stocks and vice versa at such times. Bonds and equity shares have different
characteristics that can complement each other in a portfolio held by an investor. Equity shares
are riskier compared to government bonds which can generate a fixed income. A portfolio
should be balanced, and it should include a combination of risky as well as less-risky assets.

4. Describe the relationship between bond prices and interest rates

during a recession.
Bond prices and interest rates have an inverse relationship. When interest rates go up, bond
prices drop, and vice versa. During times of economic recession, interest rates in general
decline, increasing bond prices. The main reason for this is the phenomenon called flight to
quality, where investors sell high-risk investments and purchase safer investments. This was
clearly indicated by the rise of Treasury bond prices in the wake of the Global Financial
Crisis of 2008.
6. If a yield curve looks like the one shown here, what is the market
predicting about the movement of future short-term interest rates? What
might the yield curve

The flat yield curve at shorter maturities suggests that short-term interest rates are expected to fall
moderately in the near future, while the steep upward slope of the yield curve at longer
maturities indicates that interest rates further into the future are expected to rise. Because interest
rates and expected inflation move together, the yield curve suggests that the market expects
inflation to fall moderately in the near future but to rise later on.

9. Predict what will happen to interest rates on corporate bonds if

governments adopt a new regulation that guarantees payment of principal
in case of default to encourage investment in corporate bonds. Will it
affect the demand for Treasury securities?

If the government guarantees the payment of principal on a bond in case of default, it would actually
reduce the default risk for investors. Thus, the default risk premium and interest rates on
corporate bonds will decline. The demand for secured corporate bonds will increase, which will
result in a decline in the demand for Treasury securities and raise interest rates on them.
1. Assuming that the expectations theory is the correct theory of the term
structure, calculate the interest rates in the term structure for maturities
one to six years: a. 4%, 4%, 5%, 6%, 6%, 6%

b. 5%, 5%, 4%, 4%, 4%, 4%

Explain what will happen to the resulting yield curves.

2. Refer to the previous problem. Assume that instead of the expectations

theory, the liquidity premium theory holds true. What will be your answer
to parts (a) and (b), if the following liquidity premiums are expected: 0%;
0.25%, 0.5%, 0.75%, 1%, and 1.25% respectively?

The yield to maturity would be 4% for one-year bond, 4% for two-year bond, 4.33% for three-year
bond, 4.75% for four-year bond, 5% for five-year bond, and 5.15% for six-year bond. The
upward trend in interest rates will make the yield curve upward-sloping with interest rates
that rise as maturity increases.
b. The yield to maturity would be 5% for one-year bond, 5% for two-year bond, 4.66% for
three-year bond, 4.50% for four-year bond, 4.40% for five-year bond, and 4.33 % for six-
year bond. The downward trend in interest rates will make the yield curve downward-
slopping with interest rates that decline as maturity increases.

2. Refer to the previous problem. Assume that instead of the expectations theory, the liquidity
premium theory takes place. What will be your answer to parts a and b, if the following liquidity
premiums are expected? 0%; 0.25%, 0.5%, 0.75%, 1%, and 1.25% respectively?

Solution: From the previous question, we have the following yield to maturities: 4%, 4%,
4.33%, 4.75%, 5%, 5.15%. Adding liquidity premiums:
a. One year: 4 + 0 = 4%;
Two years: 4 + 0.25 = 4.25%;
Three years: 4.33 + 0.5 = 4.83%;
Four years: 4.75 + 0.75 = 5.50%;
Five years: 5 + 1= 6%;
Six years: 5.15 + 1.25 = 6.40%
b. One year: 5 + 0 = 5%;
Two years: 5 + 0.25 = 5.25%;
Three years: 4.66 + 0.5 = 5.16%;
Four years: 4.50 + 0.75 = 5.25%;
Five years: 4.40 + 1 = 5.40%;
Six years: 4.33 + 1.25 = 5.58%

3. How does the after-tax yield on a $1,000,000 municipal bond with a

coupon rate of 8% paying interest annually compare with that of a
$1,000,000 corporate bond with a coupon rate of 10% paying interest
annually? Assume that you are in the 25% tax bracket.

Solution: Municipal bond coupon payments equal $80,000 per year. No taxes are deducted;
therefore, the yield would equal 8%.
The coupon payments on a corporate bond equal $100,000 per year. But you only
keep $75,000 because you are in the 25% tax bracket. Therefore your after-tax yield
is only 7.5%

5. Debt issued by Southwest Airways currently yields 24%. A municipal

bond of equal risk currently yields 16%. At what marginal tax rate would
an investor be indifferent between these two bonds?

Debt issued by Southwest Airways currently yields 24%. A municipal bond of

equal risk currently yields 16%. At what marginal tax rate would an investor
be indifferent between these two bonds?

Solution: Corporate bonds (1 – tax rate) = Municipal bonds

24% × (1 – tax rate) = 16%
1 – tax rate = (16%/24%)
1 – tax rate = 0.67
Tax rate = 1 – 0.67
Tax rate = 0.33