Bond

Analysis
and
Valuation

Corporate Bond Information

#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?
The relationship between the two is that the price of the bond depends on its
coupon rate. These coupon rates vary so much because of the contractual provisions
of the bond and the financial strength of the company backing the bonds.

Example 1:
Issuer

Coupon
Rate

Years to
Maturity

Face
Value

Yield

Price

% change

TransPower

10%

20

$1000

8%

$1197.65

19.77%

10%

20

$1000

10%

$1000.00

0.00%

10%

20

$1000

12%

$849.30

-15.07%

Solution:

Example 2:
Issuer

Coupon
Rate

Years to
maturity

Face
Value

Yield

Price

%
change

TransPower

0%

20

$1000

8%

$208

46.48%

Semi-annual,
0%
n=40

20

$1000

10%

$142

0.00%

0%
P= $1000
x
Price

20

$1000
12%
0.208= 208
0.142= 142

208

142

$97
0.097= 97

-31.69%

97

#2 How are the ratings of these bonds determined? What

happens when the bond ratings get adjusted downwards?

The ratings of the bonds are determined by rating agencies such as

Solution:
Moodys Investors Service, Standard and Poors Corporation, Fitch
Investors Service, and etc.
The ratings are determined so as to reflect the bonds probability of
going into default. These rates are important because many banks
and other institutional investors are permitted by law to hold only
investment-grade bonds in which the ratings are at least triple B or
single A.
If the bond ratings get adjusted downwards, this would mean that
the bonds have higher required rates of return and thus, reducing
the bonds value.

Example:

# 3 During the presentation one of the clients is

puzzled why some bonds sell for less than their
faceexplain
value
others
for a at
premium.
SheIf the bonds
Jill should
thatwhile
bonds can
be issuedsell
at a discount,
par or at premium.
asks
a bargain.
are just issued,
it iswhether
selling at par.the
Afterdiscount
being issued, bonds
the couponare
rate remains
constant, however,
the yields demanded by investors
change based
on the economic and companys specific
Howwill
should
Jill respond?
factors and these factors determine the price of the bonds.

If the yields exceed the coupon rate, investors are demanding a higher rate of return than
what the company is currently paying through the coupon payment, leading to a drop in price and
vice-versa, for the premium bond. Thus, as long as the price of the bond reflects its risk level,
whether at a premium or discount from the face value, it is not selling at a bargain or over priced.

#4 What does the term yield to maturity and how is it to be

calculated?
Yield to maturity is the rate of return earned on a bond if it is held to maturity; it is
calculated through the approximate YTM formula or through interpolation to get
the exact yield

#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.
Issuer

Face
Value

Coupon
rate

Rating

Quoted
Price

Years
until
maturity

Sinking
Fund

Call
Period

Nominal
YTM

Eff
YT

ABC
Energy

$1000

5%

AAA

$703.1

20

Yes

3 years

8%

8.1

ABC

$1000

0%

AAA

$208.3

20

Yes

NA

8%

8.1

Trans
Power

$1000

10%

AA

$1902.0

20

Yes

5 years

9.07%

9.2

Telco
Utilities

$1000

11%

AA

$1206.4

30

No

5 years

9%

9.2

Solutions:

1.

8%
5%---------------1000
I= 25 x 19.793 = 494.83
703.1

P= 1000 x 0.208= 208___

8%---------------702.83

702.83

#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 them that call provisions is a provision that gives the issuer
the right to call the bond for redemption before its maturity. Bonds having such
provisions have higher coupon rates and are relatively riskier (on the point of view
of the investors/ bondholders) as compared to other bonds not having a call
provision.

#7 How should Jill go about explaining the riskiness of each bond?

Rank the bonds in terms of their relative riskiness.
The bond ratings, as determined by professional rating agencies, serve as a guide
for the investor to know how risky a bond is. Among the AAA bonds, the zero
coupon bond has the highest price risk. Among the AA bonds, the bond of Telco
Utilities has the longest maturity and no sinking fund thus it is riskier as compared
to the other bonds.
Issuer

Face
Valu
e

Coup
on
rate

Rati
ng

Quoted
Price

Years
until
matur
ity

Sinki
ng
Fund

Call
Peri
od

Nomi
nal
YTM

Effecti
ve
YTM

Ris
k
Ra
nk

ABC
Ener
gy

$10
00

5%

AA
A

$703.
1

20

Yes

3
year
s

8%

8.16
%

ABC

$10
00

0%

AA
A

$208.
3

20

Yes

NA

8%

8.16
%

Trans
Powe
r

$10
00

10%

AA

$1902
.0

20

Yes

5
year
s

9.07
%

9.28
%

Telco
Utiliti
es

$10
00

11%

AA

$1206
.4

30

No

5
year
s

9%

9.20
%

#8One of Jills best clients poses the following questions:

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 Jill
respond?