Question

Below is the listing of a bond issued by Ford Motor Company (F). Below the detail of the bond is the information on a recent sale of part of the bond issue.

1. Explain what the price of $110.529 on a $100 par value bond means in this purchase.

2. Explain how the yield to maturity of 5.267% is calculated.

3. Contrast that with the calculation of the current yield of 5.994%.

4. Explain why it matters to know if the bond pays interest monthly, semi-annually or annually.

5. This bond does not mature for almost 10 years. Explain the concept of interest rate risk in context with this bond for both the issuer and the investor.

Rating Issuer – CUSIP Coupon                 Maturity Price                       Yield to Maturity

Baa/BBB              Ford Motor                           6.625%                  10/01/2028           $110.529                      5.267%         

Moody’s                Company (F)

               

Current Yield Dated                     Minimum Size     Coupon Paid Callable

    5.994%                         04/01/1999                    5K                     Semi-Annual        No

Answer 1

a) The price of $110.529 for a bond means that it is trading at a premium. The price of a bond is also related to its credit rating. Junk bonds for example are sold at a lesser price than ones with higher ratings as there is a default risk attached with junk bonds. Thus, in this case Ford bonds have good bond rating resulting in higher price for the bond. in addition to this, the company is offering a high coupon rate making the bond more attractive to its investors thus pushing the price higher.

b) Yield to maturity is the rate of return expected on a bond when held till maturity. The rate used to discount all future cash inflows, here coupons and the par value of the bond at the end of maturity is the yield to maturity. Thus, the discount rate used for calculating the price of the bond when the bond is held till matuirty is the YTM.

The equation for YTM calculation is below:

Bond Price = CF1/(1+ytm)¹+ CF2/(1+ytm)²+....... CF10/(1+ytm)¹⁰ + Par value/(1+ytm)¹⁰

However, since there are trial and error involved in the process, and equation below can be used to calculate YTM

Apprrox YTM = (F-P/n) + C] / [ (F+P)/2,
where F= par value
P= Price
n = 20 periods
C= coupon payment seminanually



Therefore Aprrox YTM = 5.36%

c) On the contrary current yield is calculated taking into account only the present coupon divided by the price

Current yield = 6.625%*100/110.529
   = 5.994%

d) The more the compounding period greater is the effective yield on the bond as it is getting compounded more frequently.

e)Interest rate risk is associated with long term bonds like this. the longer the period the greater is the risk of interest change. If the interest or the coupon rate increases for similar bonds, the value of the present bond will decline and it will be difficult for investors to sell them in the secondary market as newer bonds would offer better returns. Thus there is both the market risk and holding period risk which is associated with the bond.

For issuers on the contrary, a decline in interest rate in the future would mean they will have to pay higher coupon as compared to its peer bonds. Thus, the one way in which they can shield is to call back the bond. However, here the bond is not callable, hence the issuer will be at risk with decreasing interest rate and would lose money in such scenario.