Suppose you are considering two possible investment opportunities: the first is a 10 year Treasury Bond and the second, is a 7 year AA-rate corporate bond.
The current real risk free rate is 3% and inflation is expected to be 1.5% for the next 2 years, 2.5% for the following 4 years, and 3.5% thereafter.
The maturity risk premium is estimated by the following formula: MRP= .02(t-1). The liquidity premium for the corporate bond is estimated to be .25%. The default risk premium can be determined from the table below.
What is the predicted yield for each of the two investments? What is the yield spread between the two?
| Bond Type |
Rate |
Corporate Bond Yield Spread = (DRP+LP) |
| U.S Treasury |
.87 |
0% |
| AAA Corporate |
.97 |
.14% |
| AA Corporate |
1.36 |
.53% |
| A Corporate |
1.75 |
.92% |