Question

Suppose a ten-year bond with a $10,000 face value pays a 5.0% annual coupon (at the end of the year), has 2 years left to maturity, and has a discount rate of 7.5%. Further suppose you purchase this bond, but then, after you purchase it, you discover that the credit (i.e. "default" risk) on the bond has increased. Ceteris paribus, it follows that the present value (i.e. the market price) would _____, and the yield would _____.

A. increase; decrease
B. increase; increase
C. decrease; increase
D. decrease; decrease

Answer 1

The present value of the bond decreases and the yield increases when the credit risk of a bond increases, reflecting investors’ demand for higher returns to compensate for the greater risk.

Step-by-step explanation:

When the credit risk of a bond increases, ceteris paribus, the present value, or market price, of the bond will decrease. Conversely, the yield required by investors to compensate for the increased risk will increase. Therefore, the correct answer to the question 'Suppose a ten-year bond with a $10,000 face value pays a 5.0% annual coupon, has 2 years left to maturity, and has a discount rate of 7.5%. If the credit risk on the bond has increased, it follows that the present value would ____, and the yield would ____?' is C. decrease; increase.

This outcome is due to investors requiring a higher return for taking on more risk, which is represented by a higher yield. At the same time, the bond's market price must decline to raise its yield to match the increased risk. This scenario is analogous to when prevailing interest rates rise in the economy, making older, lower-yielding bonds less attractive; the price must decrease to provide a competitive yield.