Suppose you are considering two possible investment opportunities; a 12-year Treasury bond and a 7-year, A-rated corporate bond. The current real risk-free rate is 4%; and inflation is expected to be 2% for the next 2 years, 3% for the following 4 years, and 4% thereafter. The maturity risk premium is estimated by this formula: MRP= 0.02(t-1)%. The liquidity premium (LP) for the corporate bond is estimated to be 0.3%. You may determine the default risk premium (DRP), given the company's bond rating, from the table :
U.S. Treasury (rate) 1.81% (CBYS=DRP+LP) -
AAA corporate (rate) 2.00 (CBYS=DRP+LP) 0.19%
AA corporate (rate) 2.68 (CBYS=DRP+LP) 0.87
A corporate (rate) 2.79 (CBYS=DRP+LP) 0.98
Remeber to subtract the bond's LP from the corporate spread given in the table to arrive at the bond's DRP. What yield would you predict for ech of these two investments?