Why are junk bonds typically issued with higher interest rates?

Why are junk bonds typically issued with higher interest rates?

• A. To compensate for higher default risk
• B. Because they have shorter maturities
• C. Because they have higher liquidity
• D. Because they are exempt from taxes

Answer: (A)

The main idea is that investors demand a risk premium for higher credit risk. Junk bonds are rated below investment grade, meaning there’s a greater chance the issuer will default and miss coupon payments or principal. To entice buyers despite that risk, the bond offers a higher interest rate (or yield) to compensate for the potential losses. This extra return over safer bonds reflects the wider credit spread that comes with weaker credit. The other factors don’t explain the higher yield as well. Maturity length and liquidity can influence yields, but junk bonds can have a range of maturities and don’t inherently carry higher liquidity. Tax exemption isn’t relevant here because junk bonds are not tax-exempt like certain municipal bonds.

The main idea is that investors demand a risk premium for higher credit risk. Junk bonds are rated below investment grade, meaning there’s a greater chance the issuer will default and miss coupon payments or principal. To entice buyers despite that risk, the bond offers a higher interest rate (or yield) to compensate for the potential losses. This extra return over safer bonds reflects the wider credit spread that comes with weaker credit.

The other factors don’t explain the higher yield as well. Maturity length and liquidity can influence yields, but junk bonds can have a range of maturities and don’t inherently carry higher liquidity. Tax exemption isn’t relevant here because junk bonds are not tax-exempt like certain municipal bonds.