Question

A bond’s credit rating provides a guide to its risk. Suppose that long-term bonds rated Aa currently offer yields to maturity of 4.8%. A-rated bonds sell at yields of 5.1%. Suppose that a 10-year bond with a coupon rate of 4.9% is downgraded by Moody’s from an Aa to A rating.

a. Is the bond likely to sell above or below par value before the downgrade?

• Above par value

• Below par value

b. Is the bond likely to sell above or below par value after the downgrade?

• Above par value

• Below par value

Answer 1

If yield to maturity is lower than the coupon rate, the bond trades above the par value because the bond pays more than the yield. Hence, the value of the bond will increase above the par value.

In the same way, if yield to maturity is higher than the coupon rate, the bond trades below the par value because the bond pays lower than the yield. Hence, the value of the bond will trade below the par value.

a. In the above, in First case, the bond trades above the par value

b. In second case, the rating has been downgraded to A and yield to maturity increases to 5.1%, then the bond trades below the par value.