This chapter discusses some of the reasons why bonds with the same structures, with regard to coupons, maturity, currency and embedded options, often yield significantly different amounts. In particular, it looks at the way both credit risk and liquidity effect the market valuation of bonds.
Both borrowers and investors are interested in bonds being rated and for them to have reasonable liquidity. From a borrower's point of view the higher the rating and increased liquidity of existing issues, the easier and possibly cheaper it is to raise new debt.
Investors like to purchase securities where there is virtually no credit risk, unless they are adequately rewarded for the risk. This presents the user with a dilemma. There is a need to assess which securities in the universe are ‘risk free’ and how risky are other securities that provide a greater return.
As has already been discussed, the market traditionally treats domestic government issues denominated in the currency of the country as risk free. Thus US Treasury dollar bonds and UK sterling gilt-edged securities are regarded as risk free, but is this a sensible assumption if the security will not be repaid for some time and the country is politically unstable? Even in the eurozone, in late 2005, the market required a yield premium of between 15 and 20 basis points for euro ten year bonds issued by Italy and Greece over those issued by Germany. This premium was in fact very similar ...