Question

On July 1, 2010, SPO Corp. sold a $900 million bond issue to finance the purchase of a new distribution facility. These bonds were issued in $1,000 denominations with a maturity date of July 1, 2040. The bonds have a coupon rate of 8.00% with interest paid semiannually.

Solve the for the following:

1. Determine the value today, July 1, 2020 of one of these bonds to an investor who requires a 6 percent return on these bonds. Why is the value today different from the par value?

2. Assume that the bonds are selling for $1,150.00. Determine the current yield and the yield-to-maturity. Explain what these terms mean.

3. Explain what layers or textures of risk play a role in the determination of the required rate of return on SPO’s bonds.

Answer 1

Answer (1) (a):

Par value = $1,000

Semiannual coupon = 1000 * 8%/2 = $40

Number of semiannual periods = 30 * 2 = 60

Semiannual required rate of return = 6%/2 = 3%

Value of one bond = PV(rate, nper, pmt, fv, type) = PV(3%,60, -40, -1000,0) = $1276.76

Value of one bond = $1,276.76

Answer (1) (b):

Value of one bond is different from par value since required rate of return is different from coupon rate.

As the required rate is lower than coupon rate, it is sold at premium.

Answer (2):

Current yield:

Current yield = Annual coupon amount / Price = 40*2 / 1276.76 = 80/1276.76 = 6.27%

Current yield = 6.27%

Yield to maturity:

Par value = $1,000

Semiannual coupon = 1000 * 8%/2 = $40

Number of semiannual periods = 30 * 2 = 60

Price = PV = $1150

Semiannual yield to maturity = RATE(nper, pmt, pv, fv, type) = RATE(60,40, -1150,1000,0) = 3.41%

Yield to maturity = 3.41% * 2 = 6.82%

Yield to maturity = 6.82%

Current yield is the bonds annual income in %age whereas Yield to maturity is return anticipated over life of the bond.

Answer (3):

Nominal return = Risk free rate + Inflation premium +Default risk premium + Maturity risk premium + Liquidity Premium

As such the layers or textures of risks that play a role in the determination of the required rate of return on SPO’s bonds:

Inflation risk: This is the risk that real dollar return would be lower than the nominal return due to inflation

Default risk: This is the risk that the company may default in paying redemtion amount.

Maturity risk: This is risk due to maturity period. Longer the maturity period, higher the risk

Liquidity risk: This is risk due to which may entail an amount when bond is required to be converted into cash.