Question

Please, give each answer in the essay format. The more explicit it is, the better. Number of points in brackets correspond to the lenght and profoundity of each essay graders expect me to show.

(c) Explain under which conditons the YTM is the appropriate measure of the bond's return, for i) a zero-coupon bond, ii) a coupon bond. [3 points) (d) Explain how the absence of default risk greatly simplifies bond valuation. [8 points] (e) What do credit spreads measure? [5 points

Answer 1

Appropriateness of YTM to measure a bond's return

Yield to maturity (YTM) is the total return anticipated on a bond if the bond is held until it matures. Yield to maturity is considered a long-term bond yield but is expressed as an annual rate. In other words, it is the internal rate of return (IRR) of an investment in a bond if the investor holds the bond until maturity, with all payments made as scheduled and reinvested at the same rate.

Yield to maturity can be quite useful for estimating whether buying a bond is a good investment. An investor will determine a required yield (the return on a bond that will make the bond worthwhile). Once an investor has determined the YTM of a bond he or she is considering buying, the investor can compare the YTM with the required yield to determine if the bond is a good buy.

Because YTM is expressed as an annual rate regardless of the bond's term to maturity, it can be used to compare bonds that have different maturities and coupons since YTM expresses the value of different bonds in the same annual terms.

YTM is best suited for Zero Coupon Bonds as there are less variables and future uncertainties.

YTM calculations usually do not account for taxes that an investor pays on the bond. In this case, YTM is known as the gross redemption yield. YTM calculations also do not account for purchasing or selling costs.

YTM also makes assumptions about the future that cannot be known in advance. An investor may not be able to reinvest all coupons, the bond may not be held to maturity, and the bond issuer may default on the bond.

Given the above limitations, YTM is only appropriate for a Coupon Bond only when there are no uncertainties in the future.

Finally, YTM is the best suited tool for comparing different bonds with varied maturity dates both for coupon and zero coupon bonds.

Absence of default risk greatly simplifies bond valuation.

While there is no possibility of default for bond issues made by the United States Treasury, corporate bonds or state/local bonds can default on interest or principal payments. If there is any possibility of default on a bond, there will be a default premium in addition to the maturity premium on the bond. The default premium will increase with the perceived default risk of the bond and is generally also a function of the maturity and terms of the specific bond.

Now, given the complexity of calculating the default premium, the absence of it greatly simplifies the bond valuation. To understand this completely lets take a look at the complexities of calculating default risk.

1 . To assign a default risk premium, first we have to calculate the default probability of a corporate.

2. Default risk is not a linear function as different corporates can have default risk for completely different reasons.

3.It is very difficult to calculate default risk of MNCs as they have capability of raising loans in different countries.

What do credit spreads measure:

A credit spread is the difference in yield between a U.S. Treasury bond and another debt security of the same maturity but different credit quality. Credit spreads between U.S. Treasuries and other bond issuances are measured in basis points, with a 1% difference in yield equal to a spread of 100 basis points. For example, a 10-year Treasury note with a yield of 5% and a 10-year corporate bond with a yield of 7% are said to have a credit spread of 200 basis points. Credit spreads are also referred to as "bond spreads" or "default spreads." Credit spread allows a comparison between a corporate bond and a risk-free alternative.

A bond credit spread reflects the difference in yield between a treasury and corporate bond of the same maturity. Debt issued by the United States Treasury is used as the benchmark in the financial industry due to its risk-free status being backed by the full faith and credit of the U.S. government. US Treasury bonds are considered to be the closest thing to a risk-free investment, as the probability of default is almost non-existent. Corporate bonds, even for the most stable and highly-rated companies, are considered to be riskier investments for which the investor demands compensation. This compensation is the credit spread.

Credit spreads vary from one security to another based on the credit rating of the issuer of the bond. Higher quality bonds, which have less chance of the issuer defaulting, can offer lower interest rates. Lower quality bonds, with a higher chance of the issuer defaulting, need to offer higher rates to attract investors to the riskier investment. Credit spreads fluctuations are commonly due to changes in economic conditions (inflation), changes in liquidity, and demand for investment within particular markets.