Question

1) The yield to maturity for 10-year bonds is as follows for 3 different bond rating categories. AAA 7.5% AA 9% A 12% The bonds of Gallagher Inc. were rated at AA and issued at par last month. The bonds have now been downgraded to A.

a) What was the price of the Gallagher bonds when they were issued? (1 mark)

b) Determine the new price of the bonds, assuming a 15-year maturity and semiannual interest payments.

c) What 2 factors might impact a bond’s rating?

Answer 1

a) Since the bonds were issued at par, these were coupon bonds paying the same rate as the YTM

So, the bonds had 9% coupon rate and were priced at par value (say $1000) at the time these were issued.

b) The new price will be as per A rating and 12% YTM (6% semiannual YTM)

Without loss of generality , let the face/par value be $1000

Semiannual interest payment= $1000*9%/2 = $45

No of coupon payments = 15*2 = 30

So, price of the bond = $45/0.06*(1-1/1.06^30)+ 1000/1.06^30

=$793.53

So, the bonds' new price will be 79.35% of the par value

c) A bond's rating may be affected by :

i) Repayment ability and financial soundness of the firm

ii) Economic conditions of the firm and business lookout in the future