Question

sation) The Financial Advisor's Investment Case High-Yield Securities and Relative Risk Stephanie Wald sultant has blossom each bond has the same rating, it seems reason- able to conclude that the probability of default is about the same for each bond. However, there may be considerable difference in their price volatility. Waldron has asked you to rank each bond from the least to the most price volatile. She also wants you to compare the bonds' price volatility with the triple-A-rated bonds with the same terms to matu- rity. To do this, you have found four A-rated bonds with the following terms: we Company Coupon E 6.50% F 10.05 Maturity Date (Years) 10 15 nie Waldron is an aggressive individual career as a self-employed management con- has blossomed. Waldron is both willing able to bear substantial risk in order to earn cher return. She is also very independent, pre- og to make her own investment decisions after Considering various alternatives. She has a Keoch account that she manages herself. Although she could select various types of mutual funds as in- sent vehicles for the account, she prefers to select specific assets. The account's value exceeds $200,000, and Waldron recently liquidated several securities whose prices had risen sufficiently so that she believed further price increases to be unlikely. As her financial planner, you believe that high- vield debt instruments would be an attractive alter native to stocks, whose prices have risen recently. High-yield securities offer larger returns but may involve substantial risk. The combination of high risk and high return are consistent with Waldron's investment philosophy, so she has asked you to suggest several alternative high-yield bonds. The terms of several B-rated bonds are as follows: Maturity Date Yield to Company Coupon (Years) Price Maturity 10% $ 900 11.75% 15 1,200 12.055 487 10.825 10 772 10.847 Price $ 900 1.200 587 772 Yield to Maturity 7.9946 8.143 7.908 7.879 H 4.05 If interest rates rise by 3 percent across the board, what will be the new price of each of the eight bonds? What do these new prices suggest about the price volatility of high-yield versus high- quality bonds? To answer this last question, com- pare bond A to bond E, B to F,C to G, and D to H. Which bonds' prices were more volatile? If two bonds with the same term to maturity sell for the same price, which bond may subject the investor to more interest rate risk? Does acquiring bonds with higher credit ratings and less default risk also imply the investor has less interest rate risk? 15 Waldron is interested in each of the bonds but has several questions concerning their risk. Since

Answer 1

Please see the table below. The second row explains the mathematics. Bonds with identical color code in last column should be compared.

Part (1) The new price has been calculated in the second last column.

Company	Coupon	Maturity	Price	YTM	New YTM	New Price	%age change
	C	n	P0	r	i = r + 3%	P1 = -PV(i, n, C x 1000, 1000)	P1/P0 - 1
A	10.00%	10	900	11.750%	14.750%	$759	-15.63%
B	15.00%	15	1200	12.055%	15.055%	$997	-16.93%
C	0.00%	7	487	10.825%	13.825%	$404	-17.05%
D	7.00%	10	772	10.847%	13.847%	$641	-17.01%
E	6.50%	10	900	7.990%	10.990%	$735	-18.28%
F	10.05%	15	1200	8.143%	11.143%	$922	-23.16%
G	0.00%	7	587	7.908%	10.908%	$484	-17.47%
H	4.05%	10	772	7.879%	10.879%	$596	-22.83%

Part (2) %age change in price in last column explains the volatility in prices. High yield bonds have lower %age change with respect to their counterpart high quality bonds. Hence, higher yield bonds are less volatile than high quality bonds.

Part (3)

• Lower coupon bonds are more volatile than higher coupon bonds, keeping everything else constant (that's why E is more volatile than A, F is more volatile than B and so on)
• Bonds with longer maturity has more volatility than that with shorter maturity. Bonds A & F have nearly same coupon rate, however F has higher maturity and hence more volatile.

Part (4) Between two bonds with same price and term to maturity, the bond with lower coupon is more volatile. Hence, E is more volatile than A, F is more volatile than B and so on. Hence, the bonds with lower coupon rate will subject the investor to higher interest rate risk.

Part (5)

Not necessarily. The interest rate risk is also a function of time to maturity and coupon rate. All the triple A rated bonds are more volatile than their counterpart B rated bonds. Hence, bonds with higher credit ratings and lower default risk need not always be less susceptible to interest rate risk.