How does the risk of a bond's credit rating typically relate to its yield and default risk?

• A. Higher credit risk corresponds to higher yield but higher default risk
• B. Higher risk reduces yield
• C. They are independent
• D. Lower risk corresponds to higher yield but lower default risk

Answer: (A)

When a bond carries more credit risk, investors require more compensation for taking on that danger, so the yield rises. A lower credit rating signals a higher probability that the issuer will default, and the potential loss from default adds to the return investors demand. In other words, riskier bonds tend to pay higher yields to entice buyers, because both the chance of not getting all payments and the potential losses are greater. The other ideas don’t fit because risk isn’t going to reduce yield, and yield does not become higher when credit risk is lower or when risk and yield are unrelated.