Question

1. On a bond, i) If the inflation rate increases would you expect the yield to maturity to rise or fall? ii) If the credit rating of a company is lowered from BBB- to BB would you expect the price of the bond to rise or to fall?
2. Why do some bonds have callable features? What is the disadvantage to the investor of a callable bond? What does the investor receive in exchange for a bond being callable? How are bond valuation calculations affected if bonds are callable?

Answer 1

a.(i)If I'm investing in a bond,and the inflation rate rises,I will expect the yield to maturity to rise.Inflation is a bond's worst enemy.The higher the inflation rises,the higher the investors will demand this risk to be compensated (inflation risk).

(ii)A bond is considered investment grade if it's rated between AAA and BBB-. The closer to AAA, the safer the bond. A bond is considered investment grade or IG if its credit rating is BBB- or higher.

As B lies before BBB- , the price of the bond will fall because they don't have high risks associated with them.These are known as high yield bonds because they are not investment grade bonds.

b.Some bonds have callable features so that the issuer may redeem before it reaches the stated maturity date. In essence, a callable bond allows the issuing company to pay off their debt early. A business may choose to call their bond if market interest rates move in a favorable direction and will allow them to borrow at a more beneficial rate.

Many bonds are callable to give the issuer the option of calling the bond in and refunding (reissuing) the bond if interest rates decline. Bonds issued in a high interest rate
environment will have the call feature. Interest rates must decline enough to offset the cost of floating a new issue. The disadvantage to the investor is that the investor will not receive that long stream of constant income that the bondholder would have received with a noncallable bond. In return, the yields on callable bonds are usually slightly higher than the yields on noncallable bonds of equivalent risk. When the bond is called, the investor receives the call price (an amount greater than par value). The bond valuation calculation should include the call price rather than the par value as the final amount received; also, only the cash flows until the first call should be discounted. The result is that the investor should be looking at yield to first call, not yield to maturity, for callable bonds.