Question

In chapter 6, Bond Valuations techniques are introduced A bond is a debt security, like ‘IOU.’ The bond issuers borrow from the Bond Investors. The issuers agree to repay the principal amount of the loan on the maturity date. Thus, a bond represents loans from the holder to the issuer. In this assignment, you are to discuss the following with numerical examples:

1..What does it mean when a bond sells at a premium or when it sells at a discount?

2.Discuss the relation between a corporate bond’s expected return and the yield to maturity; define default risk and explain how these rates incorporate default risk.

3 .Assess the creditworthiness of a corporate bond using its bond rating; define default risk.

Answer 1

1. Bond selling at premium or when it sells at a discount

When Bonds are selling at premium, it means that the bond selling price is higher than the face value. If it is at discount it means it is selling lesser than the face value. Normally when interest rates of the bond is higher than the market rates, the price of the bond will be higher. It also depends on the credit worthiness of the bond as investors will be ready to pay for a bond which is more credit worthy.

2. Bond relation between expected return and YTM, default risk and how it is incorporated

Expected return is the coupon rate payments which bond will pay the investor periodically while YTM is the estimated rate of return on the market value basis assumptions like investor will hold the bond till maturity date etc. Coupon rate is a part in YTM calculations. The relation between both is that if the bond is issued at face value, generally YTM and coupon rate may remain the same. If bond is issued at premium, the YTM will be lower than the coupon rate and vice versa when it is issued at discount.

Default risk for bond is the risk that the company issuing the bond may default in the bond repayment or interest repayment. Generally if a bond is risky, they may offer higher yield / returns.

3. Credit worthiness using bond rating and default risk

As mentioned above, default risk for bond is the risk that the company issuing the bond may default in the bond repayment or interest repayment.

There are various agencies who measure credit worthiness of the bond which is disclosed as credit rating. They are generally categorized into investing bond or non investing bond. Considering a agency- Standard & Poor as example, AAA to BBB- is the rating provided for investment bonds while BB+ to D is provided for non investment bond. Below these are bonds which have already defaulted.