Yield rate risk free rate risk premium both the

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Yield Rate = Risk-Free Rate + Risk Premium Both the treasury yield (the so-called risk-free rate) and the corporate yield vary over time illustrated in the following graphic. Treasury and Corporate 10-Year Bond Yields 2000-2010 10% 8% '0 6% Qi >= 4% 2% 0% V / / / ( ( ( ( ( ( / 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 The rate of interest that investors expect for a particular bond is a function of the risk-free rare and the risk premium, where the latter depends on the creditworthiness of the issuing entity.
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Module 7 I Liability Recognition and Nonowner Financing 7-22 yield increases (shifts upward) as debt quality moves from Treasury securities (gener- idered to be risk free), which is the highest-quality debt reflected in the lowest line in h, to the Aaa (highest) rated corporates and, finally, to the Baa (lower-rated) corporates in this graph. That is, higher credit-rated issuers warrant a lower rate than lower credit- issuers. This difference is substantial. For example, in December of 2010, the average treasury bond yield is 3.29%, while the Aaa corporate bond yield is 5.02% and the _ Baa (the lowest investment grade corporate bond) yield is 6.10%. Accounting Conservatism and Cost of Debt rch indicates that companies that use more conservative accounting policies incur a lower of debt. Research also suggests that while accounting conservatism can lead to lower-quality unting income (because such income does not fully reflect economic reality), creditors are confident in the numbers-and view them as more credible. Evidence also implies that compa- can lower the required return demanded by creditors (the risk premium) by issuing high-quality cial reports that include enhanced footnote disclosures and detailed supplemental reports. Are Credit Ratings? pany's credit rating, also referred to as debt rating, credit quality, or creditworthiness, is to default risk. Default refers to the nonpayment of interest and principal and/or the failure to to the various terms and conditions (covenants) of the bond indenture. Companies that want . bond financing from the capital markets, normally first seek a rating on their proposed -- uance from one of several rating agencies such as Standard & Poor's, Moody's Investors - e, or Fitch Ratings. The aim of rating agencies is to rate debt so that its default risk is more ely conveyed to, and priced by, the market. Each rating agency uses its own rating system, as - it 7.5 shows. This exhibit includes the general description for each rating class- for example, - is assigned to debt of prime maximum safety (highest in creditworthiness). -- - -- --~ --_.- EXHIBIT 7.5 Baa1 Baa2 Baa3 Corporate Debt Ratings and Descriptions S&P Fitch Description AAA AAA Prime Maximum Safety AA+ AA+ High Grade, High Quality AA AA AA- AA- A+ A+ Upper-Medium Grade A A A- A- BBB+ BBB+ Lower-Medium Grade BBB BBB BBB- BBB- BB+ BB+ Non-Investment Grade BB BB Speculative BB- BB- B+ B+ Highly Speculative B B B- B- CCC+ CCC Substantial Risk CCC In Poor Standing CCC- Extremely Speculative May be in Default DDD Default DD D D Moody's Aaa Aa1 Aa2 Aa3 Ai A2 A3 Ba1 Ba2 Ba3 B1 B2 B3 Caa1 Caa2 Caa3 Ca C
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