.Which description most accurately summarizes the yield curves shown?
a.Lower credit debt has higher borrowing costs and longer maturities always have lower borrowing costs
b.Lower credit debt has higher borrowing costs and term premium spreads widen with longer maturities
c.Lower credit debt and longer maturities always have higher borrowing costs
The correct answer and explanation is:
Correct Answer: b. Lower credit debt has higher borrowing costs and term premium spreads widen with longer maturities
Explanation:
1. Lower Credit Debt and Higher Borrowing Costs
Debt instruments issued by entities with lower credit ratings (e.g., speculative-grade or high-yield bonds) carry a higher risk of default. To compensate investors for this risk, these instruments offer higher yields compared to higher-rated (investment-grade) debt. This higher yield is a reflection of the credit risk premium. In other words, investors demand more return to compensate for the greater uncertainty and likelihood of loss.
2. Term Premium and Longer Maturities
The term premium is the additional yield investors require to hold longer-maturity bonds instead of shorter-term instruments. It reflects factors such as interest rate risk, inflation expectations, and opportunity cost over time. For lower credit debt, the term premium tends to widen as maturity increases, because longer time horizons exacerbate the risk of default, economic changes, and market volatility.
For example, a 5-year bond from a high-yield issuer may carry a much higher spread over Treasury yields than a 1-year bond, even from the same issuer, due to heightened risk over the longer term. This widening of term spreads highlights how maturity compounds credit and market risks.
3. Why “a” and “c” Are Incorrect
- Option a: While lower credit debt does have higher borrowing costs, the assertion that “longer maturities always have lower borrowing costs” is incorrect. Longer maturities typically have higher yields due to the term premium.
- Option c: Longer maturities and lower credit debt generally do have higher borrowing costs, but the word “always” is problematic. Yield curves can invert or flatten under specific market conditions, such as during economic uncertainty.
Thus, option b best captures the behavior of yield curves by accurately describing the relationship between credit quality, maturity, and borrowing costs.