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 explain the relationship between coupon rates and bond prices by calculating the price of the bonds, which have similar features except coupon rate.
Let’s compare ABC Energy issuer with the coupon rate 5% and 0% (the same with rating and YTM) IssuerMaturityFace ValueCoupon RateRatingYieldPrice% Change ABC Energy2010005%AAA2%$1,490.54 49.05%
ABC Energy2010005%AAA3%$1,297.55 29.75%
ABC Energy2010005%AAA5%$1,000.00 0.00%
ABC Energy2010005%AAA6%$885.30 -11.47%
ABC Energy2010000%AAA2%$672.97 -32.70%
ABC Energy2010000%AAA3%$553.68 -44.63%
ABC Energy2010000%AAA5%$376.89 -62.31%
ABC Energy2010000%AAA6%$311.80 -68.82%
The table shows that the 5% coupon bond has a wider fluctuation in price than the zero coupon bond for equivalent changes in yield.
2. How are the ratings of these bonds determined? What happens when the bond ratings get adjusted downwards?
The ratings of these bonds are determined by two professional bond-rating firms: Moody’s and Standard & Poor’s (S&P). Each of these bond-rating firms has a committee that evaluates the risk level of the company’s bond issue. It assigns a rating ranging from AAA or Aaa (best rating) down to D (default). The ratings are periodically re-evaluated whenever there is a significant development in a company’s structure or earning performance. When the ratings get adjusted downward, the bond becomes less attractive. Hence, the rate of return goes up to reduce its price.
3. During the presentation one of the clients is puzzled why some bonds sell for less than their face value while others sell for premium. She asks whether the discount bonds are a bargain. How should Jill respond?
Bonds can be issued at a...