Question

Macy's bonds are currently rated BBB. They have a yield of 8.5%, treasury bonds with a similar maturity have a yield of approximately 1%. If you reinvest your coupons into the bonds, and if Macy's does not default what is the expected return to maturity on Macy's bonds?

-Approximate 1%

- More than 1% but less than 8.5%

-Approximate 8.5%

-More than 8.5%

Answer 1

Assume Par Value=$1000

Number of Years =5

Expected Cash flow :

Annual Coupon =8.5%*1000=$85

Payment at maturity(assuming no default)=$1000

Future Value of annual cash flow with 1% yield:

Compound amount factor (CAF)=(F/A,i,N)=(((1+i)^N)-1)/i

i=yield =1%=0.01

N=Number of years=5

CAF=(F/A,1%,5)=((1.01^5)-1)/0.01=5.101005

Future Value of annual cash flow with 1% yield=$85*CAF=85*5.101005=$433.59

Total Amount available after 5 years =$433.59+$1000=$1433.59

Assume expected return on maturity =R

1000*((1+R)^5)=1433.59

(1+R)^5=1433.59/1000=1.43359

1+R=1.43359^(1/5)=1.074694

R=0.074694=7.47%

The Return is more than 1% but less than 8.5%

More than 1% but less than 8.5%