Consider the following four debt securities, which are identical in every characteristic except as noted:
W: A corporate bond rated AAA
X: A corporate bond rate BBB
Y: A corporate bond rated AAA with a shorter time to maturity than bonds W and X
Z: A corporate bond rated AAA with the same time to maturity as bond Y that trades in a more liquid market than bonds W, X, or Y.
List the bonds in the most likely order of the interest rates (yields to maturity) of the bonds from highest to lowest. Explain your work.
The bond with the highest risk is going to be your BBB bond. A BBB bond is rated at a higher risk and will most likely yield the highest interest rates. BBB bonds fall into what is considered to be a lower medium grade bond and is just above the non-investment grade of bonds. The next below in high risk is going to be your AAA rated bond. AAA bonds are very low in risk in nature depending on their yield to maturity. The AAA bond is placed here because we are unaware of the duration of the bond. That is why the next less risky bond is the AAA bond with a shorter time to maturity than W and X. The reason behind this is that the bond has a less likely chance of its value being diminished. The longer the term, the higher the chance there is that something could happen in the market that could destroy the wealth of the bond. The least risky of the bunch is going to be bond Z that trades in a more liquid market than the others. The reason this is less risky is because there are a larger number of sellers and buyers in this type of market which makes getting rid of an unwanted bond much easier than it would in a less liquid market. So in summary, the highest interest rate would be X as it is a corporate bond with a rating of BBB. The next highest interest rate would be W since it is still a corporate bond but has a better rating of AAA. The next option