Question

ABC Bonds are currently rated AA. The bonds mature in 10 years and have a coupon...

ABC Bonds are currently rated AA. The bonds mature in 10 years and have a coupon rate of 6.5%. You are convinced that the bonds will be downgraded to BBB 1 year from now. If AA bonds have a YTM of 7% and BBB bonds have a YTM of 8.6%, what is your rate of return on a 1-year investment in ABC Bonds if they are downgraded at the end of the year? Answer to 4 decimal places, for example 0.1234.

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Answer #1

Assuming Face value = 100
YTM = 7%
Coupon rate = 6.5%|
Coupon = Coupon Rate * Face Value = 6.5% * 100 = 6.5
Maturity = 10 years
Current Market price of bond = Ct/(1+YTM)t + Face Value/(1+ YTM)t = 6.5/(1+ 7%)t + 100/(1+ 7%)t = 96.4882

Market Price after 1 year
Maturity = 9 years
YTM = 8.6%
Market price after 1 year = Ct/(1+YTM)t + Face Value/(1+ YTM)t = 6.5/(1+ 8.6%)t + 100/(1+ 8.6%)t = 87.2026

Rate of Return = (Market price after 1 year - Market Price paid + Coupon)/Market price Paid = (
87.2026-96.4882+6.5)/96.4882 = -0.0289 or - 2.89%

Best of Luck. God Bless

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