Suppose a client observes the following two benchmark spreads for two bonds:
Bond issue U rated A: 150 basis points
Bond issue V rated BBB: 135 basis points
Your client is confused because he thought the lower-rated bond (bond V) should offer
a higher benchmark spread than the higher-rated bond (bond U). Explain why the benchmark spread may be lower for bond U.
One would expect that absent any embedded options, the lower rated bond (bond V) would have a higher benchmark spread. For our situation, the opposite is observed in the market as the lower rated bond (bond V) has a lower benchmark spread. The reason could be one or both of the following.
First, the higher rated bond (bond U) is callable. Hence, the benchmark spread reflects compensation for the call risk. Second, the lower rated bond (bond V) may be putable or may be convertible. Either of these embedded option features could result in a lower benchmark spread relative to the higher rated bond. For example, suppose bond V is a convertible bond. It is possible that if converted it could give the owner a much greater value and in fact could conceivably give more dividend than is currently being paid to the bondholder. These aspects in turn explain why the benchmark spread may be lower for bond V.
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