Question

Suppose there are 100 zero-coupon bonds with the same maturity (duration), issued by 100 private corporations. I want you to consider how the average yield on the bonds will change from Monday to Tuesday as described below. (The average yield on these 100 bonds is the number you get by adding up all the 100 yields and dividing by 100). On Monday, everyone knows that 50 of these corporations will be bankrupt before the bonds are due. But no one knows which 50 it will be. And everyone knows that no one knows. On Tuesday, some people receive secret information that tells them exactly which 50 corporations will go bankrupt. Everyone knows that some people have received this secret information. But no one knows who has received the information. (If you received the information you know you received it, but you don't know who else received it.) From Monday to Tuesday, will the average yield on the 100 bonds rise, fall, or remain the same? Explain.

Answer 1

Average yield 100 bonds from Monday to Tuesday will rise because there is high default risk. Default risk is the chance that a company or individual will be unable to make the required payments on their debt obligation. Lenders and investors are exposed to default risk in virtually all forms of credit extension. A higher level of risk leads to higher required return and in turn a higher interest rate.