Bond Analysis and Valuation
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 explain the relationship between coupon rates and bond prices by calculating the prices of bonds, which have similar features except for their coupon rates, under different assumptions regarding the yield to maturity. [For example, the 0%, AAA-rated, 20-year ABC Energy bond and the 5%, AAA-rated. 20-year
ABC Energy bond.]
Bond Coupon Rate Maturity Face Value Rating Yield Price % Change ABC Energy 5% 20 $1,000 AAA 2% $1,490.54 49.05%
ABC Energy 5% 20 $1,000 AAA 5% $1,000.00 0.00%
ABC Energy 5% 20 $1,000 AAA 8% $705.46 -29.45%
ABC Energy 0% 20 $1,000 AAA 2% $672.97 78.56%
ABC Energy 0% 20 $1,000 AAA 5% $376.89 0.00%
ABC Energy 0% 20 $1,000 AAA 8% $214.55 -43.07%
The table shows that the 5% coupon bond has a low range fluctuation in price than the zero-coupon bond for equivalent changes in yields. 2. How are the ratings of these bonds determined? What happens when the bond ratings get adjusted downwards?
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
Jill could explain the relationship between coupon rates and bond prices by calculating the prices of bonds, which have similar features except for their coupon rates, under different assumptions regarding the yield to maturity. [For example, the 0%, AAA-rated, 20-year ABC Energy bond and the 5%, AAA-rated. 20-year
ABC Energy bond.]
Bond Coupon Rate Maturity Face Value Rating Yield Price % Change ABC Energy 5% 20 $1,000 AAA 2% $1,490.54 49.05%
ABC Energy 5% 20 $1,000 AAA 5% $1,000.00 0.00%
ABC Energy 5% 20 $1,000 AAA 8% $705.46 -29.45%
ABC Energy 0% 20 $1,000 AAA 2% $672.97 78.56%
ABC Energy 0% 20 $1,000 AAA 5% $376.89 0.00%
ABC Energy 0% 20 $1,000 AAA 8% $214.55 -43.07%
The table shows that the 5% coupon bond has a low range fluctuation in price than the zero-coupon bond for equivalent changes in yields. 2. How are the ratings of these bonds determined? What happens when the bond ratings get adjusted downwards?
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