Use the Internet resources to find and examine the average yield spr.pdf

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Use the Internet resources to find and examine the average yield spreads between the investment grade, high yield and convertible bonds. Explain the differences you find. Solution YIELD SPREAD IS THE DIFFERENCE BETVEEN DIFFERING DEBT INSTRUMENTS CALCULATING BY DEDUCTING THE YIELD OF ONE INSTRUMENT FROM ANOTHER.THE HIGHER THE YIELD SPREAD THE GREATER THE DIFFERENCE BETWEEN THE YIELD S OFFERED BY EACH INSTRUMENTS. INVESTMENT-GRADE CORPORATE BONDS (LQD) ARE DEBT SECURITIES ISSUED BY CORPORATES RATED BBB OR ABOVE BY THE CREDIT RATING AGENCIES SUCH AS STANDERD AND POOR S OR MOODEYS.THESE CORPORATES ARE ISSUED RATINGS ON THEIR FINANCIAL STRENGTH ,OPERATIONAL PAST PERFORMANCE,AND FUTURE PROSPECTS.CORPORATES WITH HIGHER EARNINGS ,WITH LIMITED DEBT EXPOSURE,AND POTENTIAL TO PERFORM TO RECEIVE GOOD CREDIT RATINGS. THE KEY DIFFERECES BETWEEN THE INVESTMENT GRADE AND HIGH YIELD BONDS ARE 1)INVESTMENT -GRADE CORPORATE BONDS CARRY LOWER RATE OF INTEREST THAN THE HIGH YIELD BONDS WITH THE SAME MATURITY DATE.2)INVESTMENT GRADE BONDS,DUE TO THEIR BETTER CREDIT PROFILE ,CARRY LESS DEFAULT RISK THAN THE HIGH YIELD BONDS.3) INVESTMENT GRADE CORPORATE BONDS WILL HAVE THE GREATER MATURITY THAN THE HIGH YIELD BONDS.THE MAXIMUM MATURITY PERIOD FOR INVESTMENT GRADE BONDS ARE 30 YEARS AND FOR THE HIGH YIELD BONDS THE MAXIMUM MATURITY WOULD BE BETWEEN 7 AND 10 YEARS.4) HIGH YIELD BONDS ARE RISKIER (AND BECAUSE OF THAT THEY TEND FOLLW STRICT RESTRICTIONSON THE COVERAGE RATIOS THE COMPANY HAS TO FOLLOW WHEN INCURRING A NEW DEBT ) THAN THE INVESTMENT GRADE BONDS..

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3 Structure of Interest Rates CHAPTER OBJECTIVES The specific objectives of this chapter are to: · ▪ describe how characteristics of debt securities cause their yields to vary, · ▪ demonstrate how to estimate the appropriate yield for any particular debt security, and · ▪ explain the theories behind the term structure of interest rates (relationship between the term to maturity and the yield of securities). The annual interest rate offered by debt securities at any given time varies among debt securities. Individual and institutional investors must understand why quoted yields vary so that they can determine whether the extra yield on a given security outweighs any unfavorable characteristics. Financial managers of corporations or government agencies in need of funds must understand why quoted yields of debt securities vary so that they can estimate the yield they would have to offer in order to sell new debt securities. 3-1 WHY DEBT SECURITY YIELDS VARY Debt securities offer different yields because they exhibit different characteristics that influence the yield to be offered. In general, securities with unfavorable characteristics will offer higher yields to entice investors. Some debt securities have favorable features; therefore, they can offer relatively low yields and still attract investors. The yields on debt securities are affected by the following characteristics: · ▪ Credit (default) risk · ▪ Liquidity · ▪ Tax status · ▪ Term to maturity The yields on bonds may also be affected by special provisions, as described in Chapter 7. 3-1a Credit (Default) Risk Because most securities are subject to the risk of default, investors must consider the creditworthiness of the security issuer. Although investors always have the option of purchasing risk-free Treasury securities, they may prefer other securities if the yield compensates them for the risk. Thus, if all other characteristics besides credit (default) risk are equal, securities with a higher degree of default risk must offer higher yields before investors will purchase them. EXAMPLE Investors can purchase a Treasury bond with a 10-year maturity that presently offers an annualized yield of 7 percent if they hold the bond until maturity. Alternatively, investors can purchase bonds that are being issued by Zanstell Co. Although Zanstell is in good financial condition, there is a small possibility that it could file for bankruptcy during the next 10 years, in which case it would discontinue making payments to investors who purchased the bonds. Thus there is a small possibility that investors could lose most of their investment in these bonds. The only way in which investors would even consider purchasing bonds issued by Zanstell Co. is if the annualized yield offered on these bonds is higher than the Treasury bond yield. Zanstell's bonds presently offer a yield of 8 percent, which is 1 percent higher than the yield offered on Treasury bonds. At this yield, some investors are willing to p ...

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