Bond X is a nonmailable corporate bond maturing in ten years. Bond Y is also a corporate bond maturing in ten years, and Bond Y is callable at any time beginning three years from now. Both bonds carry a credit rating of AA. Based on this information, identify the most accurate statement:
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A. B. C.Explanation
Let's analyze the given information and evaluate each statement to determine the most accurate one.
Statement A: Bond Y will have a higher nominal spread over a 10-year U.S. Treasury security than Bond X.
The nominal spread is the difference between the yield of a bond and the yield of a comparable risk-free benchmark, such as a U.S. Treasury security. In this case, both Bond X and Bond Y are corporate bonds, so their yields are expected to be higher than the yield of a risk-free Treasury security. However, the statement suggests that Bond Y will have a higher nominal spread than Bond X.
Since both bonds have the same credit rating of AA, it is unlikely that Bond Y would have a higher nominal spread solely due to its callable feature. Callable bonds tend to have lower yields compared to non-callable bonds with the same credit rating and maturity because the issuer has the right to redeem the bonds early. Therefore, it is not accurate to assume that Bond Y will have a higher nominal spread over a 10-year U.S. Treasury security than Bond X. Thus, Statement A is incorrect.
Statement B: The option-adjusted spread (OAS) of Bond Y will be greater than the nominal spread of Bond Y.
The option-adjusted spread (OAS) is a measure of the spread over the risk-free rate that takes into account any embedded options in a bond, such as call or put options. Bond Y is mentioned to be callable starting from three years from now. Callable bonds have an embedded call option that allows the issuer to redeem the bond before its maturity. This call option reduces the value of the bond to investors and, consequently, increases the yield spread.
Since Bond Y is callable, its OAS is likely to be greater than its nominal spread. The OAS reflects the compensation that investors require for taking on the risk associated with the embedded call option. Therefore, Statement B is accurate.
Statement C: The nominal spread of Bond X will be greater than the option-adjusted spread of Bond X.
Bond X is described as a nonmailable corporate bond maturing in ten years. Nonmailable bonds do not have any embedded call or put options, which means there are no features that would impact the bond's value and yield beyond its credit risk and market conditions.
Without any embedded options, the nominal spread and the OAS of Bond X should be the same. The nominal spread is the difference between the bond's yield and the yield of a risk-free benchmark, while the OAS adjusts the spread for any embedded options. Since Bond X does not have any embedded options, its nominal spread and OAS will be equal.
Therefore, Statement C is incorrect. The nominal spread of Bond X will not be greater than the option-adjusted spread of Bond X; they will be the same.
In conclusion, the most accurate statement is Statement B: The option-adjusted spread (OAS) of Bond Y will be greater than the nominal spread of Bond Y.