Question

During the recession in mid-2009, homebuilder KB Home had outstanding 5 -year bonds with a yield to maturity of 8.4 % and a BB rating. If corresponding risk-free rates were 3.1 % and the market risk premium was 4.7 % estimate the expected return of KB Home's debt using two different methods.

During the recession in mid-2009, homebuilder KB Home had outstanding 5-year bonds with a yield to maturity of 8.4% and a BB rating. If corresponding risk-free rates were 3.1%, and the market risk premium was 4.7%, estimate the expected return of KB Home's debt using two different methods. How do your results compare? (Note: the average loss rate for unsecured debt is about 60%. See annual default rates by debt rating here and average debt betas by rating and maturity here :) Considering the probability of default, the expected return of the bond is %. (Round to two decimal places.) Considering CAPM and given the beta for a 7-year bond, the expected return of the bond is %. (Round to two decimal places.) How do your results compare? (Select from the drop-down menu.) its promised While both estimates are rough approximations, they both confirm that the expected return of KB Home's debt is well yield.

Answer 1

1). Expected return of the bond (using probability of default) = YTM - (probability of default*loss rate)

For a BB rated bond, the probability given in the table is 2.2%

Expected return of the bond = 8.4% - (2.2%*60%) = 7.08%

2). Using CAPM:

Debt beta for a BB rated bond is 0.17, so

return = risk-free rate + debt beta*market risk premium = 3.1% + 0.17*4.7% = 3.90%

3). Both returns differ from each other but are less than the given YTM for the bond. (Exact answer cannot be given as options are not provided for this question.)

4). While both are rough approximations, they both confirm that the expected return of KB Home's debt is below its promised yield.