Question

Bananic Ltd. raised $30 million by issued a 10-year, 7 percent semi-annual coupon bonds one year ago. The bond was rated grade A when issued at par. Today, the yield-to-maturity (YTM) of the bond yields an effective annual rate of return of 12 percent.

1. a) How many bonds did Bananic issue?

2. b) Is the bond a premium bond or discounted bond today? Explain your answer without any calculation.

3. c) Determine the bond price today.

4. d) Given that the bond’s rating just dropped from A to Baa. Answer and explain your answer for the following questions [within 30 words for each of the following sub-parts].

   1. i) Will the YTM tomorrow higher or lower than today?

   2. ii) Will the bond price tomorrow higher or lower than today?

   iii) Will the coupon rate tomorrow higher or lower than today? iv) Will the current yield tomorrow higher or lower than today?

5. e) You friend, Mary, tells you that a speculator (i.e. an investor who speculates on short term profits) should purchase a higher coupon bond rather than a lower coupon bond if a credit event (a “credit event” occurs when a person or organization defaults on a significant transaction, in which he or she is unable to honor the terms of the contract entered) is foreseen. Do you agree with her? Explain your answer. [within 60 words]

Answer 1

a) Assumin par value of $1,000, number of bonds issued = 30,000,000/1,000 = 30,000 bonds

b) Since the annual YTM is greater than the annual coupon, the bond will have to be sold at a discount to acheive a higher YTM

c) PMT = (1,000 x 7%)/2 = 35 (we divide by 2 because the coupons are semi annual)

FV = 1,000

N = 10 x 2 = 20

I/Y = 12/2 = 6%

Computing PV = 713.25

The present value of the bond is $713.25

d) i) When the ratings drop, the risk of the bond increases. To compensate investors for higher risk, the yield of the bond must increase, so YTM increases.

ii) The bond price will be lower as the yield increases.

iii) The coupon rate for a bond remains fixed

iv) Current yield is the coupon payment divided by the current market price. Since price decreases and coupon remains same, the current yield increases.

e) If a credit event is forseen, the bond carries with it a lot of risk, so the bond will be sold at a steep discount. With a high coupon payment and low bond price, the current yield will be very high.