Two bonds have the same term to maturity. The first was issued by a state government and the probability of default is believed to be low. The other was issued by a corporation and the probability of default is believed to be high. Which of the following is correct?

Question

a. Because of the differences in tax treatment and credit risk, the state bond should have the higher interest rate.
b. Because they have the same term to maturity the interest rates should be the same.
c. It is not possible to say if one bond has a higher interest rate than the other.
d. Because of the differences in tax treatment and credit risk, the corporate bond should have the higher interest rate.

Answer 1

The correct answer is:

d. Because of the differences in tax treatment and credit risk, the corporate bond should have the higher interest rate.

Explanation: Generally, corporate bonds carry higher credit risk compared to government bonds, which are considered safer investments (especially state and local government bonds due to their low probability of default). As a result, investors will demand a higher interest rate (yield) for taking on the additional risk associated with the corporate bond. Additionally, many state government bonds offer tax advantages (such as being exempt from federal taxes), which can make them more attractive and lead to lower interest rates compared to corporate bonds. Thus, given these factors, the corporate bond is expected to have a higher interest rate.