An analyst is reviewing a bond for investment purposes.The bond is expected to have a default probability of 3%,with an expected loss of 75 basis points in the event of default.If the current risk-free rate is 2%,what is the minimum coupon spread needed on the bond for its expected return to match the risk-free rate?
A.90 basis points
B.120 basis points
C.180 basis points
D.240 basis points
The credit risky bond is preferable when (1 – PD) * (1 + r + z) + PD * RR > 1 + r
(1 – 3%) * (1 + 2% + z) + 3% * 75% > 1 + 2%.
Making the calculations simplifies the equation as follows:
0.97*(1.02 + z) + 0.0225 > 1.02. Hence, z > 0.00835 or 83.5 bps.