Assume the bonds below have the same term and principal and that the state or local government that issues the municipal bond has a good credit rating. Which list has bonds correctly ordered from the one that pays the highest interest rate to the one that pays the lowest interest rate?

Question

a. Corporate bond, municipal bond, U.S. government bond
b. Municipal bond, U.S. government bond, corporate bond
c. U.S. government bond, municipal bond, corporate bond
d. Corporate bond, U.S. government bond, municipal bond

Answer 1

The correct ordering of the bonds from the one that pays the highest interest rate to the one that pays the lowest interest rate is:

a. Corporate bond, municipal bond, U.S. government bond

Here's why:

1. Corporate bonds generally have the highest interest rates due to higher risk compared to the other types of bonds. Companies can default on their debts, hence investors demand a higher return.

2. Municipal bonds typically offer lower interest rates than corporate bonds because they are issued by state or local governments and often come with tax advantages. However, they generally pay more than U.S. government bonds, especially if the municipality has a good credit rating.

3. U.S. government bonds are considered the safest investment and therefore typically offer the lowest interest rates. Investors accept lower yields because of the reduced risk of default.

So, option a correctly reflects the order of interest rates from highest to lowest.