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Benares, Junela

Baylon, Angelie Dell

Cagalawan, Caryl

Flores, Meryl

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 first define bond price and coupon rate. For instance, Bond price is the amount
one pays to buy a bond, and coupon rate is the interest rate stated on a bond when it is issued.
Jill then should explain the existing relationship between bond price and coupon rate: When a
bond is first issued, it carries with it a fixed rate of interest until maturity, which we refer to as
the coupon rate. Over time, interest rates will change, but the coupon rate and the payments to
the bond issuer will remain the same. Bonds and interest rates have an inverse relationship as
when the current interest rates go up, bond prices fall and vice versa. Suppose you purchase an
investment with a fixed payment and then in a month from now you buy a different investment
having a higher rate. The first investment wouldnt be worth as much as the second. Thus, if
market interest rates rise, prices of other bonds fall because their interest rates are lower
relative to the new market rate. Coupon rate on various bonds vary depending on the type of
bond, the credit worthiness of the issuer, the duration of the bond, market conditions and many
other factors, but basically this is because different companies carry different levels of risk.
2. How are the ratings of these bonds determined? What happens when the bond ratings get
adjusted downwards?
The organizations like S&Ps and Moodys rate bonds look at an issuer's assets, debts,
income, expenses and broad financial history. In addition, special attention is given to the
trustworthiness of a company to repay previous bond issues on time and in full. The major bond
rating agencies each use a form of scholastic grading scale, with some variation of an "A+"
denoting the best rating. In the case of Moody's, ratings range from "Aaa" to "C". Typically, only
bonds issued with a "Baa" rating or above are considered "investment grade", or appropriate for
more conservative accounts and investors. Bond ratings are reviewed every six to 12 months.
However, a bond may be reviewed at any time the agency deems necessary for reasons
including: missed or delayed payments to investors, issuance of new bonds, changes to an
issuer's underlying financial fundamentals, or other broad economic developments. When the
bond ratings get adjusted downwards, bond prices are reduced and accordingly, interest rates
risk.
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, and at premium. Discount bonds are not necessarily a bargain. These bonds do not also
equate to better yield than the market is offering, just a price below par. A discount bond is one
that is currently trading for less than its par value in the secondary market.

4. What does the term yield to maturity mean and how is it to be calculated?
The Yield to Maturity or the promised yield is a long-term bond yield expressed as an
annual rate. The Yield to Maturity calculation takes into account the bonds current market
price, par value, coupon interest rate and time to maturity. It is also assumed that all coupon
payments are reinvested at the same rate as the bonds current yield. YTM is a complex but
accurate calculation of a bonds return that helps investors compares bonds with different
maturities and coupons. For example, in table 1, ABC energy, 5%, 20-year bond:
Face value= 1000, Bond price=703.1, Interest= 50

Approximate YTM =

= 7.61%

Exact YTM (trial and error): 8%


Interest:

50x 9.818 = 490.9

Principal: 1000 x 0.215 = _215_

705.9

5% -----1000-----1000

= 5% + (

8%------705.9----703.1

= 5% + 3.03%

3%

YTM EXACT=

294.1 296.9

8.03%

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 yield, also referred to as the coupon yield only takes into
consideration the fixed interest rate upon the issuance that applies to the life of the bond. Thus,
the nominal rate does not always represent the overall return. As mentioned in the previous
number, the effective YTM takes into account factors such as the interest rate in the market and
the power of compounding on the investment returns, while nominal yield does not. However, if
the bonds being compared are of similar risk, it is best to use their nominal YTMs because the
factors mentioned above are the same for these bonds and thus are less significant.
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.
Basically, bonds having call options have higher coupon payments since the call
provision allows the issuer of the bond to redeem it before its maturity. The usual reason for the
issuer to redeem the bonds is when interest rates drop. Because of higher coupon rates, callable
bonds make potential returns to be more attractive. The risk attributed to this provision is that
the investor may not fully receive all coupon payments up to the maturity date of the bond.
Another risk associated to this is the reinvestment risk or the chance that an investor will not be
able to reinvest cash flows from an investment at a rate equal to the investments current rate
of return because as to the date when the bonds are called, the market rate is relatively lower.

7. How should Jill go about explaining the riskiness of each bond? Rank order the bonds in terms of
their relative riskiness.
Ranking the bonds(1=safest) and taking into consideration the risk of these bonds (such as call
risk, reinvestment risk, maturity risk, bond price, and sinking fund effect)

ISSUER
ABC Energy

ABC Energy

Transpower

Telco Utilities

FACE

COUPON RATING

SINKING

AAA

QUOTED YEARS
UNTIL
703.1
20

1000

5%

1000

DESCRIPTION

YES

CALL
PERIOD
3 YRS

0%

AAA

208.1

20

YES

-----

No call provision, low


reinvestment risk but
high price risk

1000

10%

AA

1092.0

20

YES

5 YRS

1206.4

20

NO

5 YRS

High coupon rate,


minimal interest
rate risk
No sinking fund,
high interest rate
risk

1000

11%

AA

Shorter call period,


less reinvestment
risk

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
ABC Energy 5% Coupon bond:
PMT = 25 (semiannual); n= 40; int/yr= 2.5%; Reinvestment rate; PV= 0; CPT FV = 1685.06

Realized return= [

] 1 = 3.41% x 2 =

6.82%