Question

Suppose you are working on a bond issue for WeWork, a U.S. based firm with a BB credit rating. WeWork plans to issue 10-year par bonds with a face value of $1,000, and has not issued debt before. A competitor with a similar bond rating as WeWork issued 15-year par bonds 5 years ago with face value of $1,000 and an annual coupon rate of 6.5% (paid semi-annually). These bonds are currently trading in the market at a price of $910.88. The 15-year US Treasury bond rate 5 years ago was 2% and the yield on 10year par US Treasury bonds today is 3%. With this information, answer the following two questions. (i) What is the yield to maturity on the bonds that WeWork’s competitor issued 5 years ago? And what would be the coupon rate at which you expect WeWork could issue the 10-year par bonds today? Clearly describe the inputs to your calculations and motivate your answer. (ii) Explain why the corporate bonds issued by the competitor 5 years ago are trading below par. Also discuss how the risk of these bonds has changed over time. Are investors today more or less concerned about the interest rate risk and the credit risk of the competitor’s bonds than they were 5 years ago? Explain your answer (no calculations are needed).

Answer 1

i]

YTM is calculated using RATE function in Excel with these inputs :

nper = 10*2 (10 years left to maturity with 2 semiannual coupon payments each year)

pmt = 1000 * 6.5% / 2 (semiannual coupon payment = face value * annual coupon rate / 2. This is a positive figure as it is an inflow to the bondholder)

pv = -910.88 (current bond price. This is a negative figure as it is an outflow to the buyer of the bond)

fv = 1000 (face value of the bond receivable on maturity. This is a positive figure as it is an inflow to the bondholder)

the RATE is calculated to be 3.90%. This is the semiannual YTM. To calculate the annual YTM, we multiply by 2. Annual YTM is 7.80%

As we WeWork plans to issue the bonds at face value, the coupon rate will be equal to the YTM of the bonds.

Coupon rate at which WeWork will issue the bonds = YTM of similar bonds = 7.80%

ii]

The bonds are trading below par (at a discount) because the YTM is higher than the coupon rate.

The relationship between coupon rate and YTM is that bonds trade at a discount (below par) if the YTM is higher than coupon rate, and bonds trade at a premium (above par) if the YTM is lower than coupon rate

Interest rate risk increases with rising interest rates. This is because if interest rates rise, investors have other bonds with higher yields that they could invest in. Hence, the value of the bonds which were issued when interest rates were lower will decrease. In this case, the interest rates have risen from 2% to 3% since the bonds were issued. Hence, the bonds have more interest rate risk now

Credit risk depends on the creditworthiness and the credit rating of the issuer. As the credit rating has not changed since the bonds were issued (based on the information given in the question), the credit risk of the bonds has not changed