A new 10 year $1000 treasury bond is selling with a coupon rate of 4.5%. A corpo

Question

A new 10 year $1000 treasury bond is selling with a coupon rate of 4.5%. A corporate bond issued at the same time has a 10 year maturity, a face value of $1000 and a coupon rate of 9.5%. What is the default premium rate (%) of the corporate bonds?

After 3 years, the industry of this corporation is facing a serious decline. The price on the bonds has dropped to $750. Using a financial calculator, indicate the input values adn find the bonds yield to maturity. Very shortly thereafter the corporation announces that it will pay th coupon payments on its bonds because they have been guaranteed by an insurance company. However, they will only be able to redeem the bond at 80% of face value. Bond buyers expect the same rate of return on the bonds. Use a financial calculator to calculate the price at which the bonds will sell. Show entries.

Explanation / Answer

Answer:

Default premium rate = Coupon rate on corporate bond - Coupon rate on treasury bond (default free)

= 9.5% - 4.5% = 5%

Using financial calculator:

Current market price = PV = - $750 (outflow), Maturity value = FV = $1,000 (inflow),

Coupon = PMT = $1,000*9.5% = $95 (inflow), No of years to maturity = N = 7

find YTM?................ 15.62%

After announcement:

Maturity value = FV = $1,000*80% = $800 (inflow), YTM= Expected return = 9.5% = YTM at the beginning

Coupon = PMT = $1,000*9.5% = $95 (inflow), No of years to maturity = N = 7

Find = Current market price = PV = ? ............. - $894.04 (outflow),

Entries for issue and interest payments:

in $ Date Account title Debit Credit By Cash 1000 To Bonds payble 1000 (Being the bonds issued at face value) By Interest on bonds 95 ($1,000*9.5%) To Cash 95 (being the interest paid at each payment date)

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