Credit Risk. A bond’s credit rating provides a guide to its risk. Suppose that long-term bonds rated Aa currently offer yields to maturity of 7.5%. A-rated bonds sell at yields of 7.8%. Suppose that a 10-year bond with a coupon rate of 7.6% is downgraded by Moody’s from an Aa to A rating. (LO6-5) a. Is the bond likely to sell above or below par value before the downgrade? b. Is the bond likely to sell above or below par value after the downgrade?

Answer is given below.

Explanation:

Credit Risk

Investor stresses higher rate of return, when there is high anticipation that the borrower will run  into default. Credit risk implies that the promised yield to maturity (YTM) is higher than the anticipated harvest. The difference between the assured yield and foreseeable yield is called  default premium. The risk the bond issuer will run into insolvency is called credit risk or default  risk.

The bond’s YTM will upsurge from 7.5%to 7.8% when the professed default risk upsurges.

The share value will fall:

see image 2 for a and image 3 for b.

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