What type of corporate bond is more likely to have greater equity exposure, investment-grade bonds or high-yield bonds? Explain why

What will be an ideal response?

From a legal standpoint, investment-grade bonds will share less in equity risk associated with financial distress compared to high-yields bonds due to covenants that serve to offer better protection by safe guarding their prior and senior claims on a firm's assets and cash flows.

Per se equity risk refers to the risk involved in investing in equity. One major risk often cited is the standard deviation of changes in prices. By this measure, the equity risk in investment-grade bonds would be lower than that for high-yield bonds. In terms of a diversified investor that looks at systematic risk, this type of risk would also be lower for investment-grade bonds compared to high-yield bonds as it would have a higher sensitivity to changes in stock prices.

One importantequity risk consideration is financial distress risk because investors in equity will be the first to feel the fall-out when a firm has financial problems that can lead tobankruptcy. Thus, equity has the greatest exposure to risks associated with financial distress. This risk of default associated with financial distress is much higher for equity than bonds and especially much higher for equity compared to investment-grade bonds. Investment-grade bonds will have more legal senior claims on a firm's assets and its cash flows compared not only to equity but also to high-yield bonds. For high-yield bonds with very low credit ratings, their claims on cash flows can come close to resembling the claims of equity albeit their cash flows should always be more secure due to higher claims on assets.