Question

2. A high-yield bond with the following features: Principal $1,000 Coupon 7% Maturity 10 years Special Features company may extend the life of the bond to 16 years a) Based on the features above, what type of bond is this bond? (2 points) (b) If you expect that interest rates will be 5 percent ten years from now, how much would you currently pay for this bond? (7 points) c) What is your potential gain or loss if you buy the bond based on that expectation but interest rates are 10 percent ten years from now? (5 points) (d) If your expectation in 2(b) is correct, do you think the issuer will extend this bond? (1 point)

Answer 1

a) This type of bond gives a right to the issuer to extend the maturity of the bond by certai years. Such bonds are extendable bonds. As the rights are with issuer, these bonds can be valued like a callable bond.

b) After 10 years, we expect the interest rates to be 5%. With existing coupons of 7%, such bonds has a lower probability of getting extended as firms would prefer to issue new bonds at 5% rather than extending current bond which has a higher coupons of 7%.

We can value this bond considering 10 years maturity. We assume that present rate in the market is also 5% inorder to value the bond

N = 10

Coupons = 70

FV = 1000

IY = 5

P.V of the Bond = 70*PVIFA(5%,10) + 1,000*PVIF(5%,10)

= 70*7.7217 + 1,000*0.6139

= $1,154.42

.

d) After 10 years, we expect the interest rates to be 5%. With existing coupons of 7%, such bonds has a lower probability of getting extended as firms would prefer to issue new bonds at 5% rather than extending current bond which has a higher coupons of 7%.