Solution to Case 8

Bond Analysis and Valuation

Corporate Bonds They are More Complex Than You

Think!

1.

How should Jill go about explaining the relationship between coupon rates and
bond prices? Why do the coupon rates for the various bonds vary so much?
Jill could explain the relationship between coupon rates and bond prices by calculating
the prices of bonds, which have similar features except for their coupon rates, under
different assumptions regarding the yield to maturity. [For example, the 0%, AAA-rated,
20-year ABC Energy bond and the 5%, AAA-rated. 20-year ABC Energy bond.]
Bond

Coupon Rate

Maturity

Face Value

Rating

Yield

Price

% Change

ABC Energy

5%

20

$1,000

AAA

2%

$1,490.54

49.05%

ABC Energy

5%

20

$1,000

AAA

5%

$1,000.00

0.00%

ABC Energy

5%

20

$1,000

AAA

8%

$705.46

-29.45%

ABC Energy

0%

20

$1,000

AAA

2%

$672.97

78.56%

ABC Energy

0%

20

$1,000

AAA

5%

$376.89

0.00%

ABC Energy

0%

20

$1,000

AAA

8%

$214.55

-43.07%

The table shows that the 5% coupon bond has a wider fluctuation in price than the zerocoupon bond for equivalent changes in yields.

2.

How are the ratings of these bonds determined? What happens when the bond
ratings get adjusted downwards?
The ratings are determined by professional rating agencies such as Standard & Poors and
Moodys. Each of these rating agencies has a committee that evaluates the risk level of a
companys bond issue and accordingly assigns a rating ranging from AAA or Aaa (best
rating) down to D (default). The ratings are periodically re-evaluated whenever there is
any significant development in a companys capital structure or earnings performance.
When ratings get adjusted downward, the bond becomes less attractive and therefore its
required rate of return goes up, reducing its price.

3.

During the presentation one of the clients is puzzled why some bonds sell for less
than their face value while others sell for a premium. She asks whether the discount
bonds are a bargain? How should Jill respond?
Jill should explain that bonds can be issued at a discount, at par, or even at a premium
from face value, depending on the firms preference for the coupon rate that will be paid.
The vast majority of bonds are sold at par ($1000) with the coupon rate being set equal to
the yield that is commensurate with its rating and maturity. After being issued, however,
the yields demanded by investors will change based on economic and company-specific
factors, but the coupon rate is fixed. Thus, the price has to vary in line with the
consensus yield demanded by investors. If the yield exceeds the coupon rate, investors
are demanding a higher rate of return than what the company is currently paying via the
coupon payment, leading to a drop in price and vice-versa. Thus, as long as the yields are
a true reflection of the risk level of the bond (which would happen in efficient markets),
bond prices, whether at a discount or a premium from face value, would be just right
and not really a bargain or overpriced.

4.

What does the term yield to maturity mean and how is it to be calculated?
The yield to maturity (YTM) of a bond is the rate of return that an investor expects to
earn when he or she buys the bond at its current price, reinvests the coupons, and receives
the face value when it matures. The YTM of a bond is also known as its promised yield.
To calculate a bonds YTM we must use the following inputs:
For example: ABC Energy, 5%, 20 year, Face Value = $1000, Price = $703.1 (semiannual coupons)

PV = -$703.1; FV = $1000; N = 40; PMT = $25; CPT I = 8.03%

Quoted Years until Sinking

maturity
Fund
Price

Yield to
maturity

Issuer

Face Value

Coupon Rate

Rating

ABC Energy

$1,000

5%

AAA

$703.10

20

Yes

8.0310%

ABC Energy

$1,000

0%

AAA

$208.30

20

Yes

8.1597%

TransPower

$1,000

10%

AA

$1,092.00

20

Yes

8.9927%

Telco Utilities

$1,000

11%

AA

$1,206.40

30

No

8.9923%

5.

What is the difference between the nominal and effective yields to maturity for
each bond listed in Table 1? Which one should the investor use when deciding
between corporate bonds and other securities of similar risk? Please explain.

Nominal
Years until Sinking Call
Yield to Effective
Issuer Face Value Coupon Rate Rating Quoted Price maturity
Fund Period maturity
YTM
ABC
Energy
ABC
Energy
TransPo
wer
Telco
Utilities

$1,000

5%

AAA

$703.10

20

Yes

3 Years

8.0001%

8.1601%

$1,000

0%

AAA

$208.30

20

Yes

NA

7.9997%

8.1597%

$1,000

10%

AA

$1,092.00

20

Yes

5 Years

9.0001%

9.2026%

$1,000

11%

AA

$1,206.40

30

No

5 Years

8.9998%

9.2023%

The nominal yield to maturity on the bonds is calculated by multiplying the semi-annual
yield by 2. The effective YTM is calculated by compounding the semi-annual yield for
two periods. For example
On the ABC Energy 5%, 20 year bond, the semi-annual YTM is 4.00%. The effective
annual YTM would be calculated as ((1+.04)2)-1 = .0816 or 8.16%. Since the YTM is
merely a promised yield with the actual yield being dependent on the reinvestment rate
that each investor is able to earn, it is best to compare similar risk bonds on the basis of
their nominal YTMs.
6.

Jill knows that the call period and its implications will be of particular concern to
the audience. How should she go about explaining the effects of the call provision
on bond risk and return potential.
Jill should explain to the audience that call provisions are attached to bonds so as to allow
companies to refinance their debt at lower rates when interest rates drop. Thus, the
existence of a call provision presents a risk to the bond investor that their investment
horizon on that bond may be prematurely ended. Moreover, there is reinvestment risk
associated with callable bonds, since the bonds are called when rates are low. The
company does pay a premium (typically equal to one extra coupon) when the bond is
called. Furthermore, there is generally a deferred call period of about 5 years, during
which the bond cannot be called. In the case of callable bonds, investors should calculate
the yield to first call of the bonds and decide accordingly. For this calculation, the future

value is set equal to $1000 + 1 years coupon, and the maturity is assumed to be the
number of years until the bond becomes freely callable.
7.

How should Jill go about explaining the riskiness of each bond? Rank order the
bonds in terms of their relative riskiness.

Rating

Quoted
Price

Years until Sinking

maturity
Fund

Call
Period

Nominal
Yield to
maturity

Effective
YTM

5%

AAA

703.1

20

Yes

3 Years

8.0001%

8.1601%

1000

0%

AAA

208.3

20

Yes

NA

7.9997%

8.1597%

1000

10%

AA

1092

20

Yes

5 Years

9.0001%

9.2026%

1000

11%

AA

1206.4

30

No

5 Years

8.9998%

9.2023%

Issuer

Face
Value

Coupon
Rate

ABC Energy

1000

ABC Energy
TransPower
Telco Utilities

Risk Rank
(1=low)

The bond ratings provide a general guide as to the credit risk associated with each bond.
Within each rating though, investors need to be aware of call risk, reinvestment risk,
maturity risk, and the sinking fund provisions effect on risk. Callability makes a bond
have higher reinvestment risk. Among the AAA bonds, the zero coupon bond has no call
risk, no reinvestment risk, but the highest price risk. Among the AA bonds, Telco
Utilities bond has a longer maturity and no sinking fund making it the riskiest of the lot.
8.

One of Jills best clients poses the following question, If I buy 10 of each of these
bonds, reinvest any coupons received at the rate of 5% per year and hold them until
they mature, what will my realized return be on each bond investment? How
should she proceed?
Realized Return = [{Future Value of reinvested coupons + Face Value}/Price of Bond ]1/n - 1

Issuer

Coupon
Face Value Rate

Quoted
Price

Years until Call

maturity
Period

Nominal
Yield to
maturity

FV of
Coupon

FV of
Coupon+
Face Vaue

Realized
Return

ABC Energy

1000

5%

703.1

20

3 Years

8.0001%

$1,685.06

$2,685.06

6.82%

ABC Energy

1000

0%

208.3

20

NA

7.9997%

$0.00

$1,000.00

8.00%

TransPower

1000

10%

1092

20

5 Years

9.0001%

$3,370.13

$4,370.13

7.06%

Telco Utilities

1000

11%

1206.4

30

5 Years

8.9998%

$7,479.54

$8,479.54

6.61%

In the case of the ABC Energy, 5% coupon bond the realized return is calculated as follows:
Future Value of Reinvested Coupons: PMT = -$25 (semiannual); n = 40; i/y = 2.5%;
(reinvestment rate); PV = 0; CPT FV = $1,685.06
Realized Return = [{(1685.06+1000)/703.1}]1/40 1 = 3.41%*2= 6.82%
Note: The number of bonds purchased does not affect the realized return