Question

Your client observes the following two benchmark spreads for two bonds:

Bond issue U rated A:150 basis points
Bond issue V rated BBB: 135 basis points
Your client is confused because he thought the lower-rated bond (bond V) should offer a higher benchmark spread than the higher-rated bond (bond U). Which statement can potentially be correct for explaining this seemingly strange pattern?
a. Because bond U is puttable and bond V is callable.
b. Because bond U is non-callable and bond V is callable.
c. Because bond U is callable and bond V is non-callable.
d. Call and put feature can not explain such a pattern.

Answer 1

The pattern can be explained by the fact that bond U is callable and bond V is non-callable.

Step-by-step explanation:

The pattern of the lower-rated bond (bond V) offering a lower benchmark spread than the higher-rated bond (bond U) can be explained by the fact that bond U is callable and bond V is non-callable.

When a bond is callable, it means that the issuer has the option to redeem it before the maturity date. Callable bonds are typically issued with a higher coupon rate to compensate investors for the risk of early redemption. This higher coupon rate leads to a higher benchmark spread.

On the other hand, non-callable bonds do not have the risk of early redemption, so they are issued with a lower coupon rate. This lower coupon rate results in a lower benchmark spread compared to callable bonds.