Page 78 - Microsoft Word - 00 CIMA F1 Prelims STUDENT 2018.docx

Chapter 3

Example 7

Company X's bonds have a BBB credit rating according to Standard and
Poor's credit rating agency, while Company Y's bonds have an A rating.

Which THREE of the following statements are true?

A Both companies' bonds are investment grade

B Both companies' bonds carry a low level of risk

C The investors in Company X's bonds will require a higher rate of return
than those in Company Y's bonds

D The coupon rate on Company X's bonds will be higher than the coupon
rate on Company Y's bonds

E A movement to a BB rating would represent a downgrade for both
companies

Solution

The answer is (A), (C) and (E).

Both companies' bonds are indeed investment grade bonds (A) all ratings of
BBB and above are investment grade. However, BBB is considered to be a
medium level of risk, so both companies' bonds do not carry a low level of
risk (B).

The investors in Company X's bonds will indeed require a higher rate of return
(C) because of this higher level of risk, but that does not necessarily mean that
the coupon rate on Company X's bonds will be higher than the coupon rate on
Company Y's bonds (D) (for example the extra return could be paid in the form
of a premium on redemption, rather than necessarily as an increased coupon
rate).

BB is a lower grading than both A and BBB so a movement to a BB rating
would represent a downgrade for both companies (E).

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