What is the risk premium on AA-rated bonds with a 30-year maturity?
What is the risk premium on BBB-rated bonds with a 30-year maturity?
What is the risk premium on CCC-rated bonds with a 30-year maturity?
Given the prevailing economic conditions, which of these three categories of bonds would be the best investment? Explain your choice.
Given the prevailing conditions, I will choose a CCC-rated bond because it has a lower risk premium compared to the AA-rated bonds and BBB-rated bonds. When deciding the amount to borrow, it is important to note that the credit rating affects the cost of borrowing which is the interest rate that an issuer pays to attract buyers. It is also evident that most creditworthy issuers like blue-chip corporations with little debt, large states with economies which are diverse or the government of the United States borrow at low costs. However, less creditworthy clients are required to pay high interest rates. Also, bonds that have highest quality credit ratings always carry the lowest yields and the bonds with low credit ratings yield more. The yield is in a sense that it provides the credit worthiness scale where higher yields insinuate that the higher the yield, the higher the risk (Brigham & Houston, 2015). For this case, the CCC rated bond has high risks and high returns hence the choice.
Also, describe the various types and uses of bonds and explain how bond markets are used by institutional investors.
Individuals and institutions use bonds for saving or preserving principal, maximizing income, diversifying portfolio, and managing interest rate risk (Brigham & Houston, 2015). Today, people ignore bonds and associate them with gifts from grandparents. With regards to preservation of principal, bonds are perceived as risk-free and their ability of barring any catastrophic events, they act as an effective way to preserve principal (Brigham & Houston, 2015). Also, investors use bonds to save for the future because it is a proven method for long-time saving approach. Moreover, bonds are used to safeguard against interest-rate risk because of its inverse relationship with its current price and prevailing rates. Likewise, Brigham & Houston (2015) add that investors use bonds for diversification because it is an excellent tool for diversification given its low correlation with other asset classes.
ReferencesBrigham, E., & Houston, J. F. (2015). Fundamentals of Financial Management, Concise Edition. Mason, OH: Cengage
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