In mid-September, 2015 S&P 500 lowered the credit rating of We$ellDrugs, Inc (W$

Question

In mid-September, 2015 S&P 500 lowered the credit rating of We$ellDrugs, Inc (W$D) from AAA to AA in response to widespread outcry about the pricing of generic drugs that were recently purchased by the company. In a statement, S&P noted that lower generic prices call into question the ability of W$D ability to meet their coupon payments. W$D’s rating had been at AAA since January 2005 prior to the recent change.

a.What do you expect to happen to the price of W$D’s outstanding bonds?

b.W$D’s competitor, Healthy Lives for All, Inc (HLA) has had a credit rating of AA for the last 11 years. If the coupon on W$D’s 10 year bonds issued on October 1, 2008 is 7% what would you expect the coupon to be higher or lower on Healthy Lives for All’s 10 year bonds also issued on October 1, 2008?

c.How would the yield to maturity of the W$D and HLA bonds compare today (October, 2015) ?

d.What would happen to the yield of the W$D bonds if the Federal Reserve surprisingly announced a half-point increase in its interest rate charged to banks?

e.The market mechanism that underlies your answer in part D can be described in several steps. What are those steps? Use the hints below to complete your answer.

Hint:

Step 1: Fed increases its rate the Required Return on Debt increases

Step 2: Then investors (buy/sell) …….

Step 3: The price of ???? goes (up/down) until ….

Step 4: The yield then ….

Explanation / Answer

a) Since the credit rating of the company has reduced from AAA to AA, the price of the company's outstanding bonds will reduce. The reason for this is because of a reduction in rating, people will expect a higher return for investing in the company (as reduction in rating signifies more risk) thus making company's debt more expensive. However, the desired return on the existing bonds can be achieved only if the bond's price reduces thus, effectively increaing the yield/return (Inverse relation between price and yield). For instance, the bonds were trading at $100 and giving a coupon of 6% and thus, a return of 6%. The return on the same bond enhances if the price of the bond becomes lesser than 100.

b)On October 1, 2008, the credit rating of W$D was AAA and the credit rating of HLA was AA. SInce coupon on 10 year bonds of W$D was 7%, the coupon will be higher for HLA because the rating of HLA was lower than that of W$D signifying more risk for which investors demand a premium and thereby investors demanding a higher return.

c) As of today, the yield to maturity of both W$D and HLA's bonds will be similar because now they have the same rating of AA and in the same industry. This signifies that investing in either company involves the same amount of risk and thus, the return expectations should be similar impying same yield to maturity.

d) If the Federal Reserve surprisingly announced a half-point increase in its interest rate charged to banks, the yield of the bonds will increase further (and the price will reduce further), because with this action of the Federal Reserve, the general interest rates in the economy go up increasing all the rates in the economy be it deposits, loans, bonds, etc. The investors start selling the exisitng bonds giving lower returns and look for bonds/instruments giving higher return. Hence, the price of the existing bonds go down as required rate of return increases and thus yield on the company's bonds increases.

e)Market Mechanism Steps:

Step 1: Fed increases its rate the Required Return on Debt increases.

Step 2: Then investors sell the exisinting bonds which are offering a lower return.

Step 3: The price of existing bonds goes down until it reaches a point where the yield on the bonds become equal to the required rate of return.

Step 4: The yield on the existing bonds then goes up as the price of the bonds reduces.

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