Bond Ratings and Interest Rates

The interest rate on a corporate bond should be a function of its default risk. If the rating is a good measure of the default risk, higher rated bonds should be priced to yield lower interest rates than would lower rated bonds. The difference between the interest rate on a bond with default risk and a default-free government bond is called the default spread. This default spread will vary by maturity of the bond and can also change from period to period, depending on economic conditions. Table 3.4 summarizes default spreads in early 2003 for ten-year bonds in each ratings class (using S&P ratings) and the market interest rates on these bonds, based upon a treasury bond rate of 4%.

Table 3.4: Default Spreads for Ratings Classes: January 2004

Rating

Default Spread

Interest rate on bond

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