Please use the graphs to show what happens to the risk (yield) differential in each situation and why. Assume the corporate and Treasury bonds have the same maturity;a) If the corporate bonds are default-risk free, what could you tell about the price and yields of each?b) If the corporate bonds are now viewed as having the possibility of default, what happens in each market?c) If the corporate bonds are granted tax-exempt status, what happens in each market?d) If the corporate bonds have a longer maturity than the Treasury bonds what would happen?

Question

What will be an ideal response?

Answer 1

a) If corporate bonds are default-risk free, the risk premium would be 0 (zero) so the price and yield should be the same across both bonds.
b) If the corporate bonds are viewed as having the possibility of default, then the demand for corporate bonds will decrease, and the demand for Treasury bonds will rise; this will result in the price of Treasury bonds increasing while their yields fall, where in the corporate bond market, the price decreases and the yields increase.
c) If corporate bonds are granted tax-exempt status, the demand for these bonds will increase, their price will rise and the yield will fall. In the Treasury bond market, the demand will decrease, so the price will fall and the yield will increase.
d) If corporate bonds have longer maturity than the Treasury bonds, the demand for the corporate bonds will decrease since longer maturity bonds carry more risk. This will cause their price to fall and the yield to rise. In the Treasury bond market, the demand will increase, thus the price of the bond will rise and the yield will decrease.