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FRM Part I · FRM Exam Part I · Corporate Bonds

A 2-year annual-pay corporate bond with a face value of $100 and a 6% coupon trades at a yield to maturity of 8.00%. The risk-free (Treasury) yield for the same maturity is 5.00%. What is the yield spread of the bond over the Treasury, and what does it primarily compensate investors for?

The spread is 300 basis points, the bond yield of 8% less the 5% Treasury yield. It compensates investors for credit risk (expected loss and default risk premium) and for lower liquidity, since the Treasury yield already reflects the pure interest rate component.

  1. A300 basis points, compensation for credit risk and liquidity riskCorrect
  2. B200 basis points, compensation for credit risk and liquidity risk
  3. C300 basis points, compensation for interest rate risk only
  4. D800 basis points, compensation for credit risk and liquidity risk

Explanation

The yield spread is the bond yield minus the Treasury yield: 8.00% - 5.00% = 3.00%, or 300 bp. This spread compensates investors for expected default loss, default risk premium and liquidity. The 200 bp option uses the coupon (6%) in place of the yield. Interest rate risk is already present in the Treasury yield, so it is not the source of the spread.

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