Question

As a junior quantitative analyst on the High-Yield desk of a major Wall-Street firm, you have been asked to analyze a corporate bond with a 16% coupon
and exactly 10 years to maturity remaining. Although originally issued at par, the bond,
which had come to market five years ago, is currently trading at a yield-to-maturity of 10%

(stated as a bond-equivalent yield) reflecting the much improved credit rating of the issuer following a successful corporate restructuring.

1. (a) What should the price of the bond be today if its face value is USD 1,000? Assume that the coupons are paid out twice a year, and that the last coupon payment occurred yesterday.

2. (b) Given the current economic climate and exceedingly flat yield curve, you wonder how the bond might be trading be in a year’s time if the yield on equivalent US corporates were to remain at 10%. If the bond were to sell in one year’s time at the same price you calculated above in (a), would the bond be underpriced (i.e., a good buying opportunity), overpriced (a good selling opportunity), or fairly priced? Justify your answer: your bond trading career might be on the line.

3. (c) In an alternative scenario, you wonder what the bond’s price might be in a year’s time if the company experienced a liquidity problem and the yield were to rise to 12%. What would be the capital gain or loss on the bond if you were to sell it at the new yield and what would be your total holding return?

4. (d) Optional. What would have been your annualized capital-gains rate had you held the bond from the initial purchase?

Answer 1