Question

Suneview Ltd., a listed public company with actively traded securities, issued debentures with a total term of fifteen years and a face value of $1,000 to the public exactly five years ago for $1,000 each. The debentures were issued at an annual coupon interest rate of 12% p.a. with payments annually in arrears. Interest rates for debentures of a similar risk to those of Suneview Ltd. are currently (five years after originally being issued) being traded at a premium of 3% above the government bond rate. A new series of government bonds (Series XXIV) were issued today for a ten-year term at an annual coupon interest rate of 5% p.a. (with payments annually in arrears), a face value of $1,000 and a yield to bondholders of 7% p.a. Required:

1. Assume that a further three years has elapsed since the calculations undertaken in part a) of this question (a total of eight years after the original debenture issue) and the premium on Suneview Ltd. debentures has increased to 5% above the government bond rate. No further government bonds have been issued since Series XXIV bonds which closed trading today at a yield of 9% p.a.

1. How much would you now (a total of eight years after the original debenture issue) pay for Suneview Ltd. debentures?
2. Briefly discuss the possible ‘real-world’ factors that may have caused the differences in the premium on Suneview Ltd. debentures as compared to the government bond rate (from 3% to 5%).

Answer 1

a]

Yield on Sunview bonds = government bond yield + premium = 7% + 3% = 10%

Price of bond today is calculated using PV function in Excel :

rate = 10% (yield of similar bonds. This is the discount rate used to calculate the present value of the bond's cash flows)

nper = 10 (number of coupon payments remaining until maturity)

pmt = 120 (annual coupon payment = face value * coupon rate = 1000 * 12%)

fv = 1000 (face value receivable on maturity)

PV is calculated to be $1,122.89

b]

Yield on Sunview bonds = government bond yield + premium = 9% + 5% = 14%

Price of bond today is calculated using PV function in Excel :

rate = 14% (yield of similar bonds. This is the discount rate used to calculate the present value of the bond's cash flows)

nper = 10 (number of coupon payments remaining until maturity)

pmt = 120 (annual coupon payment = face value * coupon rate = 1000 * 12%)

fv = 1000 (face value receivable on maturity)

PV is calculated to be $895.68

c]

The factors which may have caused the difference in premium are :

• Deterioration of Sunview's financial condition, which will increase the risk to bondholders. Due to higher risk, they demand higher premium
• Higher liquidity premium due to low liquidity in Suniview bonds compared to government bonds