How does a higher credit rating affect the yield demanded by investors?

• A. Higher credit rating generally lowers yield due to reduced default risk.
• B. Higher credit rating raises yield due to higher liquidity risk.
• C. Higher credit rating has no effect on yield.
• D. Higher credit rating lowers yield due to increased coupon payments.

Answer: (A)

When evaluating bonds, credit risk drives the yield investors demand. A higher credit rating signals a lower probability of default, so investors require less compensation for bearing risk. Since yield is essentially the risk-free return plus a credit risk premium, a lower risk premium from a better rating means a lower overall yield. In practice, higher-rated bonds tend to trade at higher prices, which pushes their yields down relative to lower-rated bonds with similar features.

The other ideas don’t fit because a higher rating doesn’t raise yield for liquidity risk, and credit risk does matter for yield. Also, coupon payments aren’t automatically increased by a better rating; the rating influences yield mainly through the perceived risk and the resulting price.