Question

Eight Track Tape Entertainment, Inc., just announced that they might not be able to make their upcoming bond coupon payment, and several Wall Street analysts have just issued a report saying the danger of the company filing for bankruptcy is higher now that it was before the company’s announcement. As a result, S&P cut their rating on these bonds from B+ to C. All else equal, which of the following is most likely to happen?

Answer	Bond Price will:	Coupon Rate will:	YTM will:
A	Go up	Go down	Go down
B	Go up	Stay the same	Go down
C	Go down	Stay the same	Go up
D	Go down	Go up	Go up
E	Stay the same	Go down	Go up

Answer 1

C

Go down

Stay the same

Go up

The YTM will go up because the bond investors will demand higher yields for investing in riskier bonds. As the credit rating has gone down and the bond has become more risky, the YTM will go up.

Price of a bond is the present value of its cash flows, the cash flows being the coupon payments and maturity value. The discount rate is the YTM. Hence, YTM and bond price are inversely related. If YTM rises, bond price will fall.

The coupon rate stays fixed over the bond's life, and does not change with the credit rating of the bond