Cases in Finance 3rd Edition DeMello Solutions

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Cases in Finance 3rd Edition DeMello Solutions Manual

Solution to Case 9

Bond Analysis and Valuation

Corporate Bonds – They Are More

Complex than You Think

Questions

1. “Why is there so much variation in the coupon rates and prices of these various

bonds?” asks one of Jill’s wealthiest clients. How should Jill respond?

Jill should respond by telling the client that the bond’s coupon rate is usually a reflection

of the interest rates prevailing at the time of issue of each bond, the relative riskiness of

the issuer (as signified by its rating) and whether or not the firm had decided to

deliberately issue a pure-discount/zero coupon bond so as to not have to come up with the

periodic cash outflow necessitated by the coupon payments. In a typical “vanilla bond”

issue, the issuing firm sets the coupon rate to equal the interest rate that investors of

similar-rated, similar maturity bonds are requiring (based on their prevailing YTM) and

sells the bond at par. Subsequently, as yields change the prices will vary from the face

value of $1000. In the case of the ABC Energy bonds, the firm issued a coupon bond

which was rated AAA and had a coupon rate of 6%, since similar 20-year bonds were

yielding 6% at the time of issue. They also simultaneously issued a zero-coupon bond

with the same maturity. Currently, the price of the 6% coupon bond has gone down to

$809.10, indicating that investors are demanding a yield of around 7.91%. The zero-

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 coupon bond which is selling at a substantial discount ($211.64) is yielding around the

same rate of return (7.91%).

2. “ How are corporate bond ratings determined?” asks another client, “and how and

why do these ratings change once they are arrived at?” What should Jill say?

The ratings are determined by professional rating agencies such as Standard & Poor’s and

Moody’s. Each of these rating agencies has a committee that evaluates the risk level of a

company’s 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 company’s 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 confused about the fact that some of

these bonds sell for less than their face value while others sell at a premium. She asks

whether the cheaper bonds are a bargain. How should Jill go about clearing up her

confusion?

Jill should explain that bonds can be issued at a discount, at par, or even at a premium

from face value, depending on the firm’s 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

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 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. One of the terms that a majority of the firm’s clients had no idea about during the

survey stage was “yield to maturity.” Using the example of the bonds listed in Table 1,

explain what this term means and how one can go about calculating it.

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 bond’s YTM we must use the following inputs:

For example: ABC Energy, 6%, 20 year, Face Value = $1000, Price = $809.1 (semi-annual

coupons)

PV = -$809.1; FV = $1000; N = 40; PMT = $30; CPT I = 7.92%; P/Y=2; C/Y=2

Years
Quoted until Sinking Yield to
Issuer Face Value Coupon Rate Rating Price maturity Fund maturity
ABC Energy $1,000 6% AAA $809.10 20 Yes 7.917%
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 ABC Energy $1,000 0% AAA $211.64 20 Yes 7.917%
TransPower $1,000 10% AA $1,025.00 20 Yes 9.714%
Telco Utilities $1,000 12% AA $1,300.00 30 No 9.074%

5. During the slideshow, Jill often made reference to a corporate bond’s “nominal”

yield and its “effective” yield, leading to some clients being confused about the

definition and interpretation of each term. How should Jane explain the

difference between the “nominal” and effective yield 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.

Years Nominal
Quoted until Sinking Call Yield to Effective
Issuer Face Value Coupon Rate Rating Price maturity Fund Period maturity YTM
ABC Energy $1,000 6% AAA $809.10 20 Yes 3 Years 7.917% 8.074%
ABC Energy $1,000 0% AAA $211.64 20 Yes NA 7.917% 8.074%
TransPower $1,000 10% AA $1,025.00 20 Yes 5 Years 9.714% 9.950%
Telco Utilities $1,000 12% AA $1,300.40 30 No 5 Years 9.074% 9.279%

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 6%, 20-year bond, the semi-annual YTM is 4.00%. The

effective annual YTM would be calculated as ((1+.0395)2)-1 =.08074 or 8.074%.

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.

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 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 year’s 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 the bonds

in terms of their relative riskiness.

Years Nominal Risk

Face Coupon until Sinking Call Yield to Rank
Issuer Value Rate Rating Quoted Price maturity Fund Period maturity Effective YTM (1=low)
ABC Energy 1000 6% AAA 809.10 20 Yes 3 Years 7.917% 8.074% 1
ABC Energy 1000 0% AAA 211.64 20 Yes NA 7.917% 8.074% 2
TransPower 1000 10% AA 1025.00 20 Yes 5 Years 9.714% 9.950% 3
Telco Utilities 1000 12% AA 1300.00 30 No 5 Years 9.074% 9.279% 4

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 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 provision’s 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 Jill’s best clients poses the following question, “ If I buy 10 of each of

these bonds, reinvest any coupons received at the rate of 6% per year and hold

them until they mature, what will my realized return be on each bond

investment?” How should Jill respond?

Realized Return = [{Future Value of reinvested coupons + Face Value}/Price of Bond ] 1/n - 1

Years FV of
Face Coupon until Call Nominal Yield Coupon+FaceRealized
Issuer Value Rate Quoted Price maturity Period to maturity FV of Coupon Vaue Return
ABC Energy 1000 6% 809.10 20 3 Years 7.9171% $2,262.04 $3,262.04 7.09%
ABC Energy 1000 0% 211.64 20 NA 7.99171% $0.00 $1,000.00 7.92%
TransPower 1000 10% 1025.00 20 5 Years 9.7143% $3,770.06 $4,770.06 7.84%
Telco Utilities 1000 11% 1300.00 30 5 Years 9.0737% $9,783.21 $10,783.21 7.18%

In the case of the ABC Energy, 6% coupon bond the realized return is calculated as
follows:

Future Value of Reinvested Coupons: PMT = -$30 (semiannual); n = 40; i/y =

3%; (reinvestment rate); PV = 0; CPT FV = $2,262.04

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Cases in Finance 3rd Edition DeMello Solutions Manual

Realized Return = [{(2,262.04+1000)/809.1}]1/40 – 1 = 3.546%*2= 7.09%

Note: The number of bonds purchased does not affect the realized return

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