They Are More Complex Than You Think

1440 Words Mar 15th, 2013 6 Pages
Case 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 should explain the relationship between coupon rates and bond prices by calculating the price of the bonds, which have similar features except coupon rate.

Let’s compare ABC Energy issuer with the coupon rate 5% and 0% (the same with rating and YTM)
Issuer Maturity Face Value Coupon Rate Rating Yield Price % Change
ABC Energy 20 1000 5% AAA 2% $1,490.54 49.05%
ABC Energy 20 1000 5% AAA 3% $1,297.55 29.75%
ABC Energy 20 1000 5% AAA 5% $1,000.00 0.00%
ABC Energy 20 1000 5% AAA 6% $885.30 -11.47% ABC Energy 20
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For example, on the ABC Energy 5%, 20 year bond, the semi-annual YTM is 4%. The effective annual YTM would be calculated [(1+0.4)^2]-1 = 0.0816 or 8.16%. Since the YTM is a promise 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.

Call provisions are attached to bonds so that it allows companies to refinance their debt at lower rates when interest rates drop. 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 when the bond is called. Furthermore, there is a deferred call period for five years, which the bond can’t be called. In the case of callable bonds, investors should calculate the yield to the first call of the bonds to decide. For this calculate, the future value is set to equal to $1,000 + 1 year coupon, the maturity is assumed to be the number of years until the bond become callable.

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