Question

35. Credit Risk. A bond's credit rating provides a guide to its risk. Suppose that long-term bonds rated Aa currently offer yields to maturity of 7.5%. A-rated bonds sell at yields of 7.8%. Sud- pose that a 10-year bond with a coupon rate of 7.6% is downgraded by Moody's from an Aa to A rating. (L06-5) a. Is the bond likely to sell above or below par value before the downgrade? b. Is the bond likely to sell above or below par value after the downgrade?

Answer 1

35. Value of bond is calculated as

= Coupon payments discounted at the yield to maturity . So when the coupon rate is higher than tr yield to maturity the bond will trade at a premium and in case coupon rate is less than the yield to maturity it will trade at a discount that is lower than the par value. As the rate at which the coupon payments are discounted will be higher.

A. The bond is likely to sell at above par before the downgrade because before the downgrade happened, the coupon rate of the bond was 7.6% and the yield offered was 7.5. %. So. In this case as the coupon rate is higher than the YTM, the bond will trade above par.

B. In the second case, as the bond is downgraded , the yield offered is now higher at 7.8%. As the coupon rate is lower than the YTM, the bond will sell at a discount that is below the par value.