Question

CASE:

Atlantic Airlines Case Atlantic Airlines issued $100 million in bonds in 2008. Because of the firm's low credit rating (B3), the bonds were considered junk bonds. At the time of the issue, the 20 year bonds were paying a yield of 12 percent. Investor Tom Phillips thought the yield on the bonds was particularly attractive and called his broker, roger Brown, to ask for more information on the debt issue. Tom currently held Treasury bonds paying four (4) percent interest and corporate bonds yielding six (6) percent. He wondered why the debt issue of Atlantic Airlines was paying twice that of his other corporate bonds and eight (8) percent more than Treasury securities. His broker, Roger Brown has been a financial consultant with Merrill Lynch for 10 years and was frequently asked such questions about yield. He explained to Tom that the bonds were not considered investment grade because of the industry they were in. Bonds of airlines are considered inherently risky because of exposure to volatile energy prices and the high debt level that many airlines carry. He further explained that they frequently were labeled ""junk bonds"" because their rating did not fall into the four highest categories of ratings by the bond rating agencies of Moody's and Standard and Poor's. Questions from Tom Phillips This explanation did not deter Tom from showing continued interest. In fact, he could hardly wait to get his hands on the 12 percent yielding securities. First, he asked Roger, What is the true risk and is it worth taking? Roger explained there was a higher risk of default on junk bonds. It sometimes ran as high as 2-3 percent during severe economic downturns (compared to.5 percent for more conventional issues). Roger also indicated that although the yield at the time of issue appeared high, it could go considerably higher should conditions worsen in the airline industry. This would take place if the price of oil moved sharply upward or people began flying less due to a downturn in the economy. Roger explained that if the yield (required return) on bonds of this nature went up, the price of the bonds would go down and could potentially wipe out the high interest payment advantage.

QUESTIONS

Please share formula examples that was used in Excel.

Problem Set 6 – Atlantic Airlines

Read “Case 15 – Atlantic Airlines” and answer the following questions for the case. For these problems,

assume there are 18 years left on the bonds and the year is 2010. The bond amount is $100 million.

1. Assume the year is 2010 and there are 18 years left on the bonds that are paying a yield of 12%

annually. What is the interest payment each year?

2. What is the present value of the interest payments if the bond yield is 12% and if the current yield to

maturity on such bonds is 9%?

3. What does the present value of the interest payments represent?

4. Assume that Roger is correct and that the higher risk of default on junk bonds and conditions in the

airline industry causes the market for the bonds to go to a yield of 15%. What is the new price of the

bonds paying a yield of 12% annually?

5. What does a credit rating of B3 mean? What ratings are higher than B3? Here are some sources to help

you answer these questions:

http://www.investopedia.com/terms/b/bondrating.asp;

http://www.investopedia.com/terms/b/b3-b.asp

6. Assume that you are Tom’s financial advisor. What would you recommend that Tom do?

Answer 1

Ans: 1 Since there are no details provided in terms of repayment of the bond principal, we are working with the (normal) assumption of payment on maturity. In which case at the coupon rate of 12% and bond issue of $ 100 million, the annual interest payment shall be (100*12%) = $ 12 million annually for each of the residual 18 years to maturity.

Ans: 2 Since the current yeild to maturity for such bonds is given as 9%, the discount factor used for calculating the present value will be 9%. The sum of present value formula : PV Interest _{Period t}? = Interest Amount / (1+9%)^t

where t is the respective time period of payment of interest rate in years. The excel calculation is enclosed below :

?Hence the total of present value of all the interest payment is $ 105.07 million

Ans :3 The present value of the interest payment represent the total value of future expected income stream adjusted for the risk premium or discounted at the expected market return for such bonds; this present value of the future income stream along with the present value of maturity proceeds will also be the current market price of this bond . The current risk profile of the future cash flows expected to emanate from this bond has decreased since the time of bond issuance - the current yield to maturity at 9% is lower than the bond yield (12%) it means that either the company balance sheet and improved and/or the macro environment / industry in which the company operates has improved resulting in lower risk perception for the future cash flows.

Ans: 4 The price of the bond is simply the present value of all the future interest payments and maturity proceeds discounted at the current yield to maturity for such bonds. We are given current yield to be at 15%, hence we will discount the future annual interest payments of 12 million each year and 100 million maturity proceeds in year 18, at 15%. The sum total of this PV should be the bond price.

Hence the current bond price if the yields increase to 15% will be $ 81.62

Ans: 5 The credit rating agencies (like Moody's in this case) evaluate the industry, company and economy and then assign a cumulative rating which the reflects the probability of default on a particular bond issue. The highest rating is Aaa which is generally for large established well capitalised corporations and denotes highest level of safety for the bond subsribers. The rating scale goes like (descending order of credit worthiness) Aaa, Aa1, Aa2, Aa3, A1, A2, A3, Baa1, Baa2, Baa3, Ba1, Ba2, Ba3, B1, B2, B3, Caa1, Caa2, Caa3, Ca, C and / (means in default). Note that the ratings till Baa3 are only considered investment grade and below that range are speculative grade bonds (high yield or junk bonds). The B3 rating specifically means that though the company (at the time of issuance) is stable and does not face any significant foreseeable risks in short term, however, it faces uncertainities and exposure to business financial or economic conditions which if they deteriorate can impact the borrowers ability to pay its obligations and lead to inadequate coverage.

Ans: 6 Depending upon Tom's risk profile, the decision should be taken whether to invest in such high yeild bonds. Given that the current portfolio comprises of Treasuries and High quality corporate bonds (extrapolated from the yeild differential given to us in the case), it does not seem that Tom is a suitable candidate for this bond. Also since he seems to have displayed limited knowledge about such bonds and about bond markets in general, it would be advisable for Tom not to invest in such bonds.