Question

The following table summarizes the yields to maturity on several one-year, zero coupon securities:

Security yield

Treasury 3.15

AAA corporate 3.23

BBB corporate 4.27

B corporate 4.94

A. What is the price(expressed as a percentage of the face value) of a one-year, zero-coupon corporate bond with a AAA rating?

B. What is the credit spread on AAA-rated corporate bonds?

C. What is the credit spread on B-rated coporate bonds?

D. How does this credit spread change with the bond rating? why?

(round to nearest cent)

Answer 1

Number of compounding period (t) 1 Yield to maturity (YTM)-3.23% Assume the face value (FV) of zero coupon bond is S1,000 Calculate the price Face value (1+YTM) $1,000 (1+0.323) Price $968.71 Price Face Value $968.71x100 $1000 96.87%) Price expressed as a % to face value x100 Calculate the credit spread on AAA-rated corporate bond. Credit spread- Yield of AAA-rated corporate bond - Yield of treasury bond -3.23%-3. 15% -10.08% Calculate the credit spread on B-rated corporate bond Credit spread- Yield of B-rated corporate bond - Yiel d of treasury bond -4.94%-3. 1 5% 1.79% The credit rating a bond changes with its corresponding change in the credit risk. That means higher the risk; lower will be the rating of the bond and vice versa.

The investors demand for higher retums on risky bonds for undertaking additional risk. Therefore, the credit spread widens as the bonds rating falls with an increase in the risk.