Question

What will happen to bond prices in the market if market interest rates rise?

The following table summarizes the yields to maturity on several one-year, zero-coupon securities:

Treasury	Yield (%)
Treasury	0.9
AAA corporate	2.2
BBB Corporate	3.2
B Corporate	3.8

-What is the price (expressed as a percentage of the face value) of a one-year, zero-coupon

corporate bond with an AAA rating?

• What is the credit spread on AAA-rated corporate bonds?

• What is the credit spread on B-rated corporate bonds?

• How does the credit spread change with the bond rating? Why?

-Your firm has a credit rating of BBB. You notice that the credit spread for five-year maturity A debt is 200 basis points (2.00%). Your firm’s five-year debt has a coupon rate of 6%. You see that new five-year Treasury notes are being issued at par with a coupon rate of 1.2%. What should the price of your outstanding five-year bonds be per $1000 of face value?

Answer 1

Answer:-

What will happen to bond prices in the market if market interest rates rise?

When the interest rates rises the bond prices will fall as the fixed interest rates on bonds will fall.

The zero coupon bond with AAA rating will always trade at a discount before maturity and in general the face value is $ 100 and the price of the bond will be $ 100- 2.2 = $ 97.8.

The credit spread on AAA-rated corporate
= Yield on AAA-rated corporate bond - Treasury bond yield
= 2.2 - 0.9
= 1.3
= 130 basis points

The credit spread on B-rated corporate
= Yield on B-rated corporate bond - Treasury bond yield
= 3.8 - 0.9
= 2.9
= 290 basis points

The credit spread is less for high rated bonds whereas the spread is higher for low rated bonds . For illustration consider the part a and part b questions above where the credit spread for AAA--rated bond is lower 130 bps whereas the credit spread is more ( 290 basis points) for B-rated band. The credit spread increases when the bond is downgraded whereas the credit spread decreases when the bond rating is upgraded. The reason is that the downgraded bonds are riskier and needs higher yields to compensate the risk for investors compared to treasury yields, so the spread increases.

Given:-

Face value (FV) = 1000
Coupon rate on debt = 6 % ( Semi annually = 3%)
Coupon payments = 0.063 x 1000 = $ 30
Given Yield (Y)= Spread on A debt + Treasury notes yield
= 200 bps + 1.2% = 2% + 1.2%
   Y = 3.2%
N= 5 years

On calculating PV = 995.26