9 these yields were obtained from mr mike steelman at

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Unformatted text preview: differentiating the nominal rates of interest on various securities. 9. These yields were obtained from Mr. Mike Steelman at UBS PaineWebber, La Jolla, CA (March 25, 2002). Note that bond ratings are explained later in this chapter, on page 278. 272 PART 2 Important Financial Concepts Because the U.S. Treasury bond would represent the risk-free, long-term security, we can calculate the risk premium of the other securities by subtracting the riskfree rate, 5.68%, from each nominal rate (yield): Security Risk premium Corporate bonds (by ratings): High quality (Aaa–Aa) 6.13% 5.68% 0.45% Medium quality (A–Baa) 7.14 5.68 1.46 Speculative (Ba–C) 8.11 5.68 2.43 6.99 5.68 1.31 Utility bonds (average rating) These risk premiums reflect differing issuer and issue risks. The lower-rated corporate issues (speculative) have a higher risk premium than that of the higherrated corporates (high quality and medium quality), and the utility issue has a risk premium near that of the medium-quality corporates. The risk premium consists of a number of issuer- and issue-related components, including interest rate risk, liquidity risk, and tax risk, which were defined in Table 5.1 on page 215, and the purely debt-specific risks—default risk, maturity risk, and contractual provision risk, briefly defined in Table 6.1. In general, TABLE 6.1 Debt-Specific Issuer- and Issue-Related Risk Premium Components Component Description Default risk The possibility that the issuer of debt will not pay the contractual interest or principal as scheduled. The greater the uncertainty as to the borrower’s ability to meet these payments, the greater the risk premium. High bond ratings reflect low default risk, and low bond ratings reflect high default risk. Maturity risk The fact that the longer the maturity, the more the value of a security will change in response to a given change in interest rates. If interest rates on otherwise similar-risk securities suddenly rise as a result of a change in the money supply, the prices of long-term bonds will decline by more...
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