Question

Suneview Ltd., a listed public company with actively traded securities, issued debentures with a total term of fifteen years and a face value of $1,000 to the public exactly five years ago for $1,000 each. The debentures were issued at an annual coupon interest rate of 12% p.a. with payments annually in arrears. Interest rates for debentures of a similar risk to those of Suneview Ltd. are currently (five years after originally being issued) being traded at a premium of 3% above the government bond rate. A new series of government bonds (Series XXIV) were issued today for a ten-year term at an annual coupon interest rate of 5% p.a. (with payments annually in arrears), a face / par value of $1,000 and a current yield to bondholders of 7% p.a.

Required:

a) Given the information provided above, how much would you pay today for Suneview Ltd. debentures? Show all relevant calculations and briefly explain the basis for the change in price, if any, from the original issue price of $1,000 using appropriate finance terminology / reasoning.

b) Assume that a further three years has elapsed since the calculations undertaken in part a) of this question (a total of eight years after the original debenture issue), and the premium on Suneview Ltd. debentures has increased to 5% above the government bond rate. No further government bonds have been issued since Series XXIV bonds which closed trading today at a yield of 9% p.a.

i) How much would you now (a total of eight years after the original debenture issue) pay for Suneview Ltd. debentures?

ii) Briefly discuss the possible ‘real-world’ factors that may have caused the differences in the premium on Suneview Ltd. debentures as compared to the government bond rate (from 3% to 5%). Note: This part of the question has a different focus than the response required in part a) of this question.

Answer 1

Part (a)

Given, Yield on Government bond of similar tenure is 7% and risk premium required on similarly placed debentures is 3%.

Therefore, yield to investor of the Suneview debenture shall be 7% + 3% = 10%.

Market value of Suneview debenture with yield of 10%= $ 1,122.89 calculated using the PV function of Excel as follows:

Part (b):

It is given that after 3 more years, ie., 8 years from issue, premium has increased to 5% and yield on Government bond has risen to 9%.

Hence yield on the debenture shall be 9% + 5% = 14%.

(i)   Market value of the debenture at 14% yield and 7 years to maturity = $ 914.23

Details of calculation as given in part (a).

(ii ) Increase in premium on Suneview Ltd Debenture (from 3% to 5%) over and above the yield on Government bond is due to increase in risk perception of Suneview Ltd. This can be, in turn, due to deterioration of its financial position, industry risk, country risk etc. The increase in risk is objectively measured and indicated by deterioration in credit rating.