Corporate Bonds

Posts Tagged ‘corporate bonds’

Question: Can someone help me solve the following?

A company's 5-year bonds are yeilding 7.75% per year. The Treasury bonds with the same maturity are yielding 5.2% per year, and the real risk-free rate (r*) is 2.3%. The average inflation premium is 2.5%; and the maturity risk premium is estimated to be 0.1 x (t-1)%, where t = number of years to maturity. If the liquidity premium is 1%. What is the default risk premium on the Corporate Bonds.

Answer: Treasury bonds doesn't matter for this method/case, so just ignore it.
Assuming current rates represent risk-free rate plus sum of premiums and using simplified summation:
RE = RiskFree + Inflation + Maturity + Default + Liquidity
RE% = r* + π +MP+DP+LP = 2.3+2.5+(0.1(5-1))+DP+1 = 6.2%+DP
RE%=7.75%
7.75=DP+6.2
7.75 - 6.2 = DP
DP = 1.55%

Answ: Default risk premium on the Corporate Bonds is ≈ 1.55%

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Question: What is a disadvantage towards Corporate Bonds?

This is not compared towards stocks, I just want to know what are some disadvantages in general for Coporate Bonds, at least 2 examples.
And if it isn't too much to please include a link.

Answer: Bonds are debt instruments and the seller has an obligation to repay the bondholder. The interest is generally fixed as is the life of the bond. Stocks, especially common, are purely speculative investments by the buyer (loans if you will) that the company is not obligated to repay should they enter chapter eleven. Bond holders are much higher up the list of payees should the company go under. Common stock holders are the last to be paid. There is no legal obligation that binds the issuer to make good on the value. Preferred stocks are a couple of notches up on the ladder but usually have neither the upside nor the downside of common stocks.

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Disadvantages:
1. You will not have the potential for gain that you will with common.

2. When all is said and done in a bankruptcy you still may not recover your investment.

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