The table below shows the terms of Xcel Telecoms Ltd bonds. Both bonds were issu
ID: 2809909 • Letter: T
Question
The table below shows the terms of Xcel Telecoms Ltd bonds. Both bonds were issued 10 years ago Floating Rate Note 7% Fixed Rate Note $200 million 30 years Issue size Original maturity Current price Curent Coupon Call Protection Call Price Yield to maturity Pfice rfange since 1ssue $200 million 20 years 95 7% 1st10 105 8% $88 to $110 6% (rate resets yearly) 1st 10 years 103 $97 to $102 (a)Discuss why the price range of the floating rate note is narrower than the price range of the fixed rate note. (5 marks) (b) Explain why the price of the floating rate note is seldom the par value? (5 marks) (c) Explain why the floating rate note investor would not care much about the call price? (5 marks) (d) Evaluate the probability of a call for the fixed-rate note. Is it high or low? (5 marks)Explanation / Answer
a) The floating rate bonds offer protection against change in interest rates. When interest rate changes, the yield on floating rate bonds is adjusted to the current interest rate such that price remains at par. On the other hand, in case of fixed rate bonds, as interest rate rises, the bond price falls and as interest rate falls, bond price rises. That is duration of fixed rate bond is higher than that of floating rate bond . Thus its price is more sensitive to intetest rate movements. Hence the price range for floating rate bond is narrower than that of fixed rate bond.
b) The yield on floating rate bond is adjusted periodically to the market rates of interest when its price becomes equal to par value. However, interest rates keep on changing in between the reset dates, hence the price of floating rate bond changes accordingly and is not equal to par value. It is equal to par only on reset date.
c) A call option on bond is enjoyed by the issuer of bond which gives it a right to redeem the bond prior to maturity. The company will exercise this option only when interest rate falls, so that it can repay the bond and issue new bonds at a lower cost. The call risk that is the risk of early redemption is less in case of floating rate bonds because its yield is adjusted to reflect current market rates and hence the company has to pay lower interest rate on the bonds and there is no need of redemption. Hence floating rate investor does not care much about call price.
d) The probalilty of call of fixed rate note is high. This is because the fixed rate us 8% and the current coupon rate is 7%. Thus it is highly probable that the company will exercise the call option and redeem the old bonds by raising money through issue of new bonds at 7% yield. This will lead to a saving in interest costs for the company. Hence it may exercise call option.
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