Atlantic Airlines
Atlantic Airlines issued $100 million
in bonds in 2008. Because of the firm’s
low credit rating (B3), the bonds were
considered to be junk bonds. At the
time of issue, the 20 year bonds were
paying a yield of 12 percent.
Investor Tom Phillips thought the
yield on the bonds was particularly
attractive and called his broker, Roger
Brown, to ask for more information
on the debt issue. Tom currently held
Treasury bonds paying four percent
interest and corporate bonds yielding
six percent. He wondered why the
debt issue of Atlantic Airlines was
paying twice that of his other
corporate bonds and eight percent
more than Treasury securities.
His broker, Roger Brown had been
a financial consultant with Merrill
Lynch for 10 years and was
frequently asked such questions about
yield. He explained to Tom that the
bonds were not considered investment
grade because of the industry they
were in. Bonds of airlines are
considered to be inherently risky
because of exposure to volatile energy
prices and the high debt level that
many airlines carry. He further
explained that they frequently were
labeled “junk bonds” because their
rating did not fall into the four highest
categories of ratings by the bond
rating agencies of Moody’s and
Standard and Poor’s.
Questions from Tom Phillips
This explanation did not deter Tom
from showing continued interest. In
fact, he could hardly wait to get his
hands on the 12 percent yielding
securities. But first, he asked Roger,
“What is the true risk and is it worth
taking?”
Roger explained there was a higher
tisk of default on junk bonds. It
sometimes ran as high as 2-3 percent
during severe economic downtums
(compared to percent for more
conventional issues). Roger also
indicated that although the yield at the
time of issue appeared high, it could goRequired
considerably higher should conditions worsen in the airline industry.
This would take place if the price of oil moved sharply upward or people
began flying less due to a downturn in the economy. Roger explained that
if the yield (required retum) on bonds of this nature went up, the price of
the bonds would go down and could potentially wipe out the high interest
payment advantage.
1. If the yield in the market for bonds of this nature were to go up
to 15 percent due to poor economic conditions, what would the
new price of the bonds be? They have an initial par value of
$1,000. Assume two years have passed and there are 18 years
remaining on the life of the bonds. Use annual analysis.
2. Compare the decline in value to the eight percent initial interest
advantage over Treasury bonds (12 percent versus four percent)
for this two year holding period. Base your analysis on a
$1,000 bond. Disregarding tax considerations, would Tom
come out ahead or behind in buying the high yield bonds?
3. Recompute the price of the bonds if interest rates went up by
only one percent to 13 percent with 18 years remaining. Does
the 8 percent interest rate advantage over the two year holding
period cover the loss in value?
4. Now assume that economic conditions improve and the yield on
similar securities goes down by 2 or 3 percent over the two
years. How does Tom come out? Merely discuss the answer.
No calculation is necessary.
5. If Tom holds the bonds to maturity (and there is no default),
does the change in the required yield in the market over the life
of the bond have any direct effect on the investment?