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Chapter 6: Q.1 (page 187)
If junk bonds are 鈥渏unk,鈥� then why do investors buy them?
As a result, investors who enjoy taking on market risk typically purchase junk bonds in order to get a larger return.
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Predict what would happen to the risk premiums of municipal bonds if the federal government guarantees today that it will pay creditors if municipal governments default on their payments. Do you think that it will then make sense for municipal bonds to be exempt from income taxes?
Prior to , mortgage lenders required a house inspection to assess a home鈥檚 value and often used the same one or two inspection companies in the same geographical market. Following the collapse of the housing market in , mortgage lenders required a house inspection, but this inspection was arranged through a third party. How does the pre- scenario illustrate a conflict of interest similar to the role that credit-rating agencies played in the global financial crisis?
鈥淎ccording to the expectations theory of the term structure, it is better to invest in one-year bonds, reinvested over two years, than to invest in a two-year bond if interest rates on one-year bonds are expected to be the same in both years.鈥� Is this statement true, false, or uncertain?
Go to the St. Louis Federal Reserve FRED database, and find data on Moody鈥檚 Aaa corporate bond yield (AAA) and Moody鈥檚 Baa corporate bond yield (BAA). Download the data into a spreadsheet.
a. Calculate the spread (difference) between the Baa and Aaa corporate bond yields for the most recent month of data available. What does this difference represent?
b. Calculate the spread again, for the same month but one year prior, and compare the result to your answer to part (a). What do your answers say about how the risk premium has changed over the past year?
c. Identify the month of highest and lowest spreads since the beginning of the year 2000. How do these spreads compare to the most current spread data available? Interpret the results.
Risk premiums on corporate bonds are usually anticyclical; that is, they decrease during business cycle expansions and increase during recessions. Why is this so?
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