FINANCIAL MARKET

CASE STUDY: 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 first understand both the coupon rate and the bond price by definition. Then
explain the relationship between both terms by calculating the prices of bonds, which have some
similar features except for their coupon rates, under different assumptions. Jill should focus more
on how the coupon rates influences the bond price. A bond's coupon rate isn't affected by its
price. However, the coupon rate influences the bond's price, by influencing the bond's
competitiveness and value in the open market. If a coupon is higher than the prevailing interest
rate, the bond's price rises; if the coupon is lower, the bond's price falls.
The table below demonstrate the relationship between both terms stated above by computing the
bond price.

The Table above shows the relationship between quoted price and coupon rate .There are
four bonds namely the ABC Energy with 5% and 0% coupon rate, Trans Power with 10%
coupon rate and Telco Utilities with 11% coupon rates. Though it sells at a discount from their
fair value and have a lower coupon rate, both is rated AAA. While the Telco utilities and the
Trans power both sells at a premium and have a much higher coupon rate and both are rated AA.
2. How are the ratings of these bonds determined? What happens when the bond ratings
get adjusted downwards?
Two specialist bond-rating agencies, Moody’s and Standard & Poor’s assess the ratings
of these bonds. Each of these bond-rating companies has a committee that assesses the
company’s bond issue’s risk level. It assigns a grade from AAA or Aaa (highest) to D (lowest)
(default). When a company’s structure or earnings output undergoes substantial change, the
scores are re-evaluated on a regular basis. If the bond’s rating are reduced, it becomes less
desirable. As a consequence, the rate of return increases in order to lower the price.

3. During the presentation, one client 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?

Majority of the bonds are issued at par, but bonds can also be issued at a discount or a
premium depending on the level of interest rates. The price of the bond will vary depending on
the yield demanded by the investors. After the issuance of bonds, the yields will change, but
coupon rate will remain constant. If the yield is greater than the coupon rate, investors will
demand for a rate of interest that is somewhat higher than the coupon rate, leading to a discount
otherwise, premium. As long as the yield stand as a true reflection of the bond’s risk level, there
will be no bargain for the discounted bonds or overpricing for bonds sold at a premium.

4. What does the term “yield to maturity” mean and how is it to be calculated?

Face Quoted Years until

Issuer value Coupon rate Rating price maturity Sinking fund Yield to maturity
ABC Energy $1,000 5% AAA $703.10 20 Yes 8.0310%
ABC Energy $1,000 0% AAA $208.30 20 Yes 8.1597%
TransPower $1,000 10% AA $1,092 20 Yes 8.9927%
Telco
Utilities $1,000 11% AA $1,206.40 30 No 8.9923%

Yield to maturity is defined in the Essentials of Financial Management book by Brigham,

Houston, Hsu, Kong and Banny-Ariffin as the rate of return earned on a bond if it is held to
maturity. They also stated that yield to maturity may be referred to as the bond’s promised rate of
return which is the return that investors would obtain once all of the promised payments are
made. When an investor purchase a bond at its quoted price, give back the payments and earns
the face value upon maturity, the rate of return can be viewed as yield to maturity. To solve for
the yield to maturity through Excel’s RATE function, the number of years until maturity (nper),
payment (pmt), present value (pv) and future value (fv) must be identified. All of these are given
in the table above except for the payment. It is computed by multiplying the face value of the
bond by its given coupon rate.
For example:

ABC Energy nper = 20 pmt = 50 (1,000 x 5%) pv = -703.10 fv = 1,000

Solutions (Excel's RATE function) RATE(nper, pmt, pv, [fv], [type], [guess])

ABC Energy RATE(20,50,-703.1,1000)

ABC Energy RATE(20,0,-208.3,1000)

TransPower RATE(20,100,-1092,1000)
Telco Utilities RATE(30,110,-1206.4,1000)

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.
 Face Coupon Rati Quoted Years until Sinking Call Nominal yield to Effective
Issuer value rate ng price maturity fund period maturity YTM
ABC
Energy $1,000 5% AAA $703.10 20 Yes 3 years 8.0001% 8.1601%
ABC
Energy $1,000 0% AAA $208.30 20 Yes NA 7.9997% 8.1597%
TransPo
wer $1,000 10% AA $1,092 20 Yes 5 years 9.0001% 9.2026%
Telco $1,206.4
Utilities $1,000 11% AA 0 30 No 5 years 8.9998% 9.2023%

The normal yield to maturity is computed by multiplying the semi-annual yield by two
(2). Meanwhile, the effective yield to maturity (YTM) is computed by compounding the semi-
annual yield for two (2) periods. For example on the case of ABC energy 5%, 20 year bond, the
semi-annual YTM is 4%. The effective annual YTM would be calculated as
((1+ 0.04)¿¿ 2)−1=¿ ¿ 0.0816 or 8.16%. However, since it is still best to compare similar risk
bonds on the basis of their nominal YTMs because, YTM is merely a promised yield with the
actual yield still being dependent on the reinvestment rate that each investor would be able to
earn.

6. Jill knows 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.
Regarding the effects of the call provision on bond risk and return potential Jill should
explain to the audience that calls provisions are added to bonds so that businesses can refinance
their debt at cheaper rates as interest rates fall. As a result, the presence of a call provision
exposes the bondholder to the possibility of their investment horizon on that bond being
prematurely terminated. Further, since callable bonds are named when interest rates are low,
there is a risk of reinvestment. When the bond is named, the company pays a premium (usually
equivalent to one additional coupon). Also, most bonds have a 5-year deferred call duration after
which the bond cannot be called. When it comes to callable bonds, investors can determine the
yield to first call and make their decision based on that. Lastly, for the calculation, the future
value is set to $1000 + 1 year's coupon for this measure, and the maturity is set to the number of
years before the bond becomes freely callable.
7. How should Jill go about explaining the riskiness of each bond? Rank order the bonds in
terms of their relative riskiness.
A bond rating is like a grade given to a bond through a rating service that indicates its
credit quality. Moreover, it represents the creditworthiness of corporate or government bonds.
On the contrary, the zero-coupon bond has no call risk, no reinvestment risk, but the highest
price risk among the AAA bonds. Telco Utilities' bond is the riskiest of the AA bonds because it
has a longer lifespan and no sinking fund.
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 5% per year and hold them until they mature,
what will my realized return be on each bond investment?” How should she proceed?

1
Realized return = [Future value of reinvested coupons + Face value} / Price of bond ¿ ¿ n −1

The realized return of ABC Energy with 5% coupon bond is calculated as:
Future value of reinvested coupons:
PMT = -$25 (semi-annually); n = 40; i/y = 2.5%; PV= 0 (Note: I used excel for this one)
FV = $1,685.06
1
Realized return = [$1,685.06+ $1,000} / 703.1 ¿ ¿ 40 −1

= 3.41%*2(semi-annual)
= 6.82%