Question
Assume today is April 1, 2021 and that all bonds pay interest semi-annually with a face value of $1,000. YTM = Current yield + Capital
Assume today is April 1, 2021 and that all bonds pay interest semi-annually with a face value of $1,000. YTM = Current yield + Capital Gains yield; CY = Annual Interest/Current Price
ABC is A rated; AA Treasuries yield 3-year is 1.25%, 10-year 1.75%
A rated bonds should yield (return) 0.25%-0.75% more than AA bonds.
5 Years ago, ABC issued 7% coupon paying bonds with a face value set to mature on April 1, 2031. Growth concerns have forced monetary authorities throughout the world to lower interest rates during the past several years and as such, the price of these ABC bonds has risen to $1150.00.
- What is yield to maturity for an investor who buys the bonds today at the current price?
- Is the bond trading at a premium, discount or at par? Explain what your answer means.
- What is the current yield of this bond and what does it measure?
- What is the capital gains yield of this bond and interpret what the sign of the CGY means?
- What would happen to the price of the bond you calculated in 1 if ABC became the subject of a lawsuit alleging accounting fraud, which results in the CFO and CEO resigning?
- Ignoring the scenario in question 5 and focusing on the information given, do you think ABC would call the bonds if they could? WHY? Suppose that the bonds were callable in 3 years at 1050. Calculate the yield to call. Which rate here is more relevant, the YTM or the YTC? Explain why.
- List two factors that would increase the riskiness of a bond as it relates to a change in interest rates.
For Questions 8 and 9 Assume that the bonds pay interest annually this will simplify the work!!!
- Calculate your annualized return if you assume that you buy the bonds today and that you sell the bond in 3 years when the YTM of the bond is at 7%. Assume that the interest you are paid is reinvested at an annual rate of 4%. Make sure you calculate your annualized return using the EAR formula. This is a 3-year return problem!! Comment on why your return is different than the YTM you calculated in question 1.
- Calculate the Macaulay Duration and Modified Duration for this bond based on todays price. Given your calculations estimate what would happen to the price of the bonds if interest rates were to rise 1% from current (todays levels). Assume the change is immediate and dissect the change in price due to duration and compare it to the actual calculated change in price. Why do you think the calculations are different?
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