Question

Approximately what is (How Much is) the Risk Premium spread for BBB (or Baa) bonds above the comparable Treasury note? That is, how much additional return ("Risk Premium") do investors require, on average, to invest in lower grade BBB bonds?

If today I was to buy a Treasury NOTE that has a maturity of five years, what rate of interest could I expect to get on my investment?

I am looking to buy some bonds. These bonds mature in exactly seven years from today, have a 2% coupon that is paid semi-annually and are priced to provide a Yield to Maturity today of 2.5%.

How much will I have to pay (excluding any commissions) for one bond?

In the previous question (I am looking to buy some bonds. These bonds mature in exactly seven years from today, have a 2% coupon that is paid semi-annually and are priced to provide a Yield to Maturity today of 2.5%,)...

Assume that I buy the bond for the price we calculated in the previous question, hold the bond for Two Years and am able at that time to sell them for PAR value. What is my annual rate of return for the two years that I held them?

Answer 1

Ans: By comparing the yield on a 5 year US Corporate BBB bond i.e. 4.38% as on 06th Feb 2019 and 5 Year Yield of Treasury Note issued on 31.01.2019 is 2.576% this difference of 4.38% - 2.576% = 1.804% is nothing but the Risk Premium which an Investor required to invest in the Lower Rated Corporate Bond of the same tenure as Treasury Note.

Treasury Note issued on 31.01.2019 is giving a high yield of 2.576% with interest rate of 2.500% thus on an investment of 1000 i could expect =1000*2.50% = 25 as coupon payment per year.

Assuming that Par Value of the Bonds we would like to buy is $100

With Coupon Rate of 2% nad Yeild to Maturity 2.5% Semiannually we would use the following equation to find the price of the bond

Equation to be used in Bond Pricing = Coupon Payment * [1- (1+r)^-n / r] + Par Value / (1+rate)^n

Here Coupon Payment = 100*(0.02/2) = 1 as it is semi annual

Rate = 2.5% / 2 = 1.25% for semiannual period; Nper = 7*2 = 14; Par Value = 100

Substituting all the values in the equation we would get the Price of the Bond as

Bond Price = 1* [1-(1+0.0125)^-14 / 0.0125] + 100 / (1+0.0125)^14 = 96.807

We have the current price of the Bond as $96.807 with Par Value as $100

If we hold the bond for two years to get it reach its Par Value, to get the Annual Rate of Return we have used the RATE function of excel

Rate function in excel =RATE(Nper,,PV,[FV],0)

Here Nper = 14; PV= 96.807 and FV= -100 i.e. Par Value

Substituting the Values in the Formula we would get Rate = 1.64%

Thus our Annual Rate of Return is 1.64%