Question

4) You are holding a bond in your investment account, and when you check the account today you find the value of the bond has increased since you first bought it. List all the possible reasons why the price of the bond went up, and explain why these factors would have resulted in a price increase.

5) A company issues two different types of bonds: callable bonds and puttable bonds. The bonds have the same maturity date. If the company went on to perform really well in the future, so that they were viewed by the market as significantly less risky than when these bonds were first issued, which of the bonds would experience the greater change in price? Explain why.

6) A company recently paid out a $4 per share dividend on their stock. Dividends are projected to grow at a constant rate of 5% into the future, and the required return on investment is 8%. If we buy the stock today and hold it for one year, what is our holding period return for that one year?

Answer 1

4)

The following factors cause an increase in the price of a bond.

1. When the bond's purchase price in the secondary market was less than par. If the bond was trading at a discount to par value (i.e. price was below the par value) when it was bought in the scondary bond market, it's price will gradually rise and converge towards the par value as the date of maturity comes closer. Hence the bond price will show an increase in value today, vis a vis its purchase price.
2. A decrease in inflation rates and Treasury rates. A decrease in inflation rates results in lower treasury yields. A reduction in Treasury rates by the Fed in order to stimulate business spending also results in lower Treasury yields. As the treasury yields falls, the discount rate (yield) of all other corporate bonds also fall. This fall in yield will result in an increase in the price of the bond, since they share an inverse relationship.
3. Changes in the credit rating of a company: Rating agencies like Standard and Poor, Fitch and Moody's not only rate the bond issues of a company, but they also rate the company itself. An improvement in the credit rating of a company means that the company can access debt at a cheaper cost than before. This results in decrease in the discount rate, which in turn causes the price to rise.

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