Explanation:
C is correct. The yield on a corporate bond is composed of a risk-free return (which is the return that would be earned on a similar risk-free instrument) and a credit spread (which is the extra return to compensate the investor for the possibility of a default).
A is incorrect. If the price of a bond increases, its yield declines (and vice versa).
B is incorrect. As the maturity of the bond increases, the credit spread for a bond with a good credit rating tends to increase. This is because the chance of a highly-rated firm defaulting increases over time as economic and business conditions change.
D is incorrect. Higher rated bonds have a lower credit spread and as such a lower yield. See explanation for C.
Learning Objective: Describe features of bond trading and explain the behavior of bond yield.
Reference: Global Association of Risk Professionals, Financial Markets and Products (New York, NY: Pearson, 2023). Chapter 17. Corporate Bonds
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Q-7. A financial advisor is explaining the basics of bond trading to a client. The advisor focuses on the connections between the credit spread of a bond and that bond's yield. Which of the following statements would the advisor be correct to make to the client?
A
When the credit spread on a bond decreases, the yield on that bond will increase.
B
As the maturity of a bond increases, the credit spread increases for lower-rated bonds and decreases for higher-rated bonds.
C
US corporate bonds pay a higher yield than US treasury bonds to compensate the buyer for taking more risk.
D
Higher-rated bonds pay a higher yield because they have a higher credit spread.
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