Investment and Portfolio Management

TOPIC 7 – TUTORIAL 7

1. Define the following types of bonds:

a. Catastrophe bond—A bond that allows the issuer to transfer “catastrophe risk” from the
firm to the capital markets. Investors in these bonds receive a compensation for taking on the
risk in the form of higher coupon rates. In the event of a catastrophe, the bondholders will
receive only part or perhaps none of the principal payment due to them at maturity. Disaster
can be defined by total insured losses or by criteria such as wind speed in a hurricane or
Richter level in an earthquake.

b. Eurobond—A bond that is denominated in one currency, usually that of the issuer, but
sold in other national markets.

c. Zero-coupon bond—A bond that makes no coupon payments. Investors receive par value
at the maturity date but receive no interest payments until then. These bonds are issued at
prices below par value, and the investor’s return comes from the difference between issue
price and the payment of par value at maturity (capital gain).

d. Samurai bond—Yen-dominated bonds sold in Japan by non-Japanese issuers.

e. Junk bond—A bond with a low credit rating due to its high default risk; also known as
high-yield bonds.

f. Convertible bond—A bond that gives the bondholders an option to exchange the bond for a
specified number of shares of common stock of the firm.

g. Serial bonds—Bonds issued with staggered maturity dates. As bonds mature sequentially,
the principal repayment burden for the firm is spread over time.

h. Equipment obligation bond—A collateralized bond for which the collateral is equipment
owned by the firm. If the firm defaults on the bond, the bondholders would receive the
equipment.

i. Original issue discount bond—A bond issued at a discount to the face value.

j. Indexed bond— A bond that makes payments that are tied to a general price index or the
price of a particular commodity.

k. Callable bond—A bond that gives the issuer the option to repurchase the bond at a
specified call price before the maturity date.

i. Puttable bond—A bond that gives the bondholder the option to sell back the bond at a
specified put price before the maturity date.
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2. A bond with an annual coupon rate of 4.8% sells for $970. What is the bond’s current yield?
Annual coupon rate: 4.80% à $48 Coupon payments
Current yield:
æ $48 ö
ç ÷ = 4.95%
è $970 ø

3. Consider a bond with a 10% coupon and yield to maturity = 8%. If the bond’s yield to maturity
remains constant, then in one year, will the bond price be higher, lower, or unchanged? Why?
Coupon rate =10% > YTM 8%
ð Price > Face Value
ð 1 year later, price of the bond will be lower as it will approach par as maturity decreases
(with an assumption of constant YTM)

4. Assume you have a 1-year investment horizon and are trying to choose among three bonds.
All have the same degree of default risk and mature in 10 years. The first is a zero-coupon
bond that pays $1,000 at maturity. The second has an 8% coupon rate and pays the $80 coupon
once per year. The third has a 10% coupon rate and pays the $100 coupon once per year.
If all three bonds are now priced to yield 8% to maturity, what are the prices of:
(i) the zero- coupon bond;
(ii) the 8% coupon bond;
(iii) the 10% coupon bond?

Zero coupon 8% coupon 10% coupon

Current prices $463.19 $1,000.00 $1,134.20

5. A newly issued 20-year maturity, zero-coupon bond is issued with a yield to maturity of 8%
and face value $1,000. Find the imputed interest income in: (a) the first year; (b) the second
year; and (c) the last year of the bond’s life.

The price schedule is as follows:

Imputed Interest
Remaining Constant Yield Value (increase in constant
Year Maturity (T). $1,000/(1.08)T yield value)
0 (now) 20 years $214.55
1 19 231.71 $17.16
2 18 250.25 18.54
19 1 925.93
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20 0 1,000.00 74.07

6. A 30-year maturity, 8% coupon bond paying coupons semiannually is callable in five years at
a call price of $1,100. The bond currently sells at a yield to maturity of 7% (3.5% per half-
year).
a. What is the yield to call?
b. What is the yield to call if the call price is only $1,050?
c. What is the yield to call if the call price is $1,100 but the bond can be called in two years
instead of five years?
a. The bond sells for $1,124.72 based on the 3.5% yield to maturity.
[n = 60; i = 3.5; FV = 1000; PMT = 40]
Therefore, yield to call is 3.368% semiannually, 6.736% annually.
[n = 10 semiannual periods; PV = –1124.72; FV = 1100; PMT = 40]
b. If the call price were $1,050, we would set FV = 1,050 and redo part (a) to find that
yield to call is 2.976% semiannually, 5.952% annually. With a lower call price, the yield
to call is lower.
c. Yield to call is 3.031% semiannually, 6.062% annually.
[n = 4; PV = −1124.72; FV = 1100; PMT = 40]

7. A bond makes semi-annual interest payments at a coupon rate of 4.8% per year on 15 January
and 15 July each year. What is the accrued interest (per $100 of face value) if the bond changes
hands on 27 March 2020? (Give your answer to 3 decimal places.)
Convention: 30/360
Days from the last coupon payments: From 15th Jan to 27th Mar
Days between coupon payments: From 15th Jan to 15th July
Periodic payment = (4.8% of $100)/2 = $2.4
Accrued interest = Periodic payment * (days from the last coupon payments / days between coupon
payments)
= 2.4 * (15 + 30 + 27) / 180 = 0.96
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8. Assume that two firms issue bonds with the following characteristics. Both bonds are issued
at par.

Ignoring credit quality, identify four features of these issues that might account for the lower
coupon on the ABC debt. Explain.
Factors that might make the ABC debt more attractive to investors, therefore justifying a lower
coupon rate and yield to maturity, are:

i. The ABC debt is a larger issue and therefore may sell with greater liquidity.
ii. An option to extend the term from 10 years to 20 years is favorable if interest rates 10 years
from now are lower than today’s interest rates. In contrast, if interest rates increase, the investor
can present the bond for payment and reinvest the money for a higher return.
iii. In the event of trouble, the ABC debt is a more senior claim. It has more underlying security in
the form of a first claim against real property.
iv. The call feature on the XYZ bonds makes the ABC bonds relatively more attractive since ABC
bonds cannot be called from the investor.
v. The XYZ bond has a sinking fund requiring XYZ to retire part of the issue each year. Since
most sinking funds give the firm the option to retire this amount at the lower of par or market
value, the sinking fund can be detrimental for bondholders
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Extra Exercises:

1. Treasury bonds paying an 8% coupon rate with semiannual payments currently sell at par
value. What coupon rate would they have to pay in order to sell at par if they paid their coupons
annually? (Hint: What is the effective annual yield on the bond?)

The effective annual yield on the semiannual coupon bonds is

EAR = (1 + 4%) 2 – 1 = 8.16%
If the annual coupon bonds are to sell at par they must offer the same yield, which requires
an annual coupon rate of 8.16%.

2. A large corporation issued both fixed- and floating-rate notes five years ago, with terms given
in the following table:

a. Why is the price range greater for the 6% coupon bond than the floating-rate note?
Fixed coupon paying bond: IR increases => RRR increases => Price of bond decreases
Floating coupon paying bond: IR increases => coupon rate increases => Price of bond decreases
at a lower speed / increases
For fixed coupon paying bond, the interest rate changes will have higher impact than for floating
coupon paying bond
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b. What factors could explain why the floating-rate note is not always sold at par value?
Sold a par value => P = FV => c = y
Coupon rate = 1 year T-Bill rate + 2%
At the issue time: 2% premium is enough
After time: risk of issuers may change => 2% premium is not enough: too low/too high
=> c # y => Price # FV

c. Why is the call price for the floating-rate note not of great importance to investors?
Call option:
Fixed coupon paying bond: if IR reduces
ð c>y
ð Issuers will call the bond back to avoid paying high fixed coupon
Floating coupon paying bond: if IR reduces
ð coupon rate reduces
ð NO advantages for the issuers to call the bonds back
ð Call option is not relevant for floating coupon paying bond

d. Is the probability of a call for the fixed-rate note high or low?

The probability of a call for the fixed-rate note depends on IR
ð IR increases or decreases?
6% coupon notes are issued 5 years ago
Normally, bonds are issued at par: c = y = 6% 5 years ago
Now: y = 6.9%
ð Interest rate increases
ð Low probability of the call

e. If the firm were to issue a fixed-rate note with a 15-year maturity, what coupon rate would it
need to offer to issue the bond at par value?
Issue the bond at par value => c = y
Existing bonds with 15 more years to maturity, YTM = RRR = 6.9%
ð Investors require at least RRR of 6.9% for a 15-year bond
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ð New bond has to offer the same RRR

ð Issue at par: c = y = RRR = 6.9%

e. Why is an entry for yield to maturity for the floating-rate note not appropriate?
For a floating coupon paying bond, future coupons are variable and cannot be estimated
ð Cannot work out YTM

3. A floating rate bond has a face value of $1000 and makes semi-annual coupon payments on
1 February and 1 August each year.
The reference rate for the bond is BBSW.
The bond has a rating of BB+, credit spreads is 211 basis point (1 basis point = 0.01%)
The BBSW took on the following values on the following dates:
1 February 2017 – 2.34%
1 August 2017 – 2.52%
1 February 2018 – 2.17%
1 August 2018 – 2.44%
What was the coupon payment on 1 February 2018?
Credit spreads is 211 basis point = 2.11%
Floating coupon rate = base rate + fixed premium = BBSW + fixed premium
Coupon rate = 2.52% + 2.11% = 4.63%
Coupon payment = 4.63% * $1000 * ½ = $23.15