Introduction to Corporate Finance

PArT 2: VALUATION, rISk AND reTUrN

TABLe 4.4 THE RELATIONSHIP BETWEEN BOND RATINGS AND SPREADS AT DIFFERENT MATURITIES IN THE

US AT A GIVEN POINT IN TIME, EXPRESSED IN BASIS POINTS

The table shows the difference in yields, at given points in time, between US corporate bonds in different ratings categories

and US Treasury securities having the same maturity. For instance, five-year bonds with a AAA rating offered a yield that

was 29 basis points higher than the five-year US Treasury note at the given point in time. Note that yield spreads rise with

maturity just as they rise as the bond rating falls.

Rating 1 yr. 2 yr. 3 yr. 5 yr. 7 yr. 10 yr. 30 yr.

Aaa/AAA 10 12 23 29 46 58 78

Aa1/AA+ 19 27 28 40 56 69 90

Aa2/AA 21 33 35 44 59 71 93

Aa3/AA– 22 36 37 49 63 75 101

A1/A+ 44 49 53 61 76 90 113

A2/A 47 52 55 63 78 92 117

A3/A– 51 55 58 67 81 95 118

Baa1/BBB+ 59 69 77 87 117 139 165

Baa2/BBB 62 77 5 92 124 147 172

Baa3/BBB– 69 82 87 97 129 154 177

Ba1/BB+ 330 340 350 360 380 400 420

Ba2/BB 340 350 360 370 390 410 430

Ba3/BB– 350 360 370 380 400 420 440

B1/B+ 470 480 490 520 560 600 650

B2/B 480 490 500 530 570 610 660

B3/B– 490 500 510 540 580 620 670

Caa/CCC 890 900 910 935 945 955 985

Thus far, we have maintained a simplifying assumption in our valuation models. You can see that

assumption embedded in Equations 4.1 and 4.2. Both equations assume that we can apply a single

discount rate, r, to determine the present value of cash payments made at any and all future dates. In

other words, the models assume that investors require the same rate of return on an investment that pays

cash one year from now and on one that pays cash 10 years from now. In reality, required rates of return

depend on the exact timing of cash payments, as the next section illustrates.

CONCEPT REVIEW QUESTIONS 4-4

12 Calculate a bond’s yield to maturity using its last price along with its coupon rate, par value and

maturity date.

13 The price of a certain corporate bond is quoted as 97.847. What is the dollar price of this bond if its

par value is $1,000?

14 Explain why the yield spread on corporate bonds versus government bonds must always be

positive. How do these spreads change: (a) as the bond rating declines; and (b) as the time to

maturity increases?

A bond with a B rating offers

a yield to maturity of 8%. Is

the market’s required return on

this bond less than, equal to, or

greater than 8%?

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question