Question

Bond X is a bond with a coupon rate of 18 percent that makes annual payments. It has a poor rating that bond issuer might not pay the interest and/or principal payments. Bond Y is a bond with a coupon rate of 6 percent that makes semi-annual payments. It is actively traded on the secondary market. Both bonds have face value of $1,000 with eight years to maturity and the current yield to maturity (YTM) is 8 percent. (a) Based on the provided information, determine and explain whether Bond X and Y is selling at premium, discount or par without using any calculation respectively. (b) Determine the current yield of Bond X and Bond Y respectively. (c) Based on the provided information, identify TWO different risk premiums in bond X and Y respectively. Briefly describe how each of these risk premiums affects a bond's required return.

Answer 1

Bond X is likely selling at a premium due to its high coupon rate of 18% compared to the current YTM of 8%, while Bond Y is likely selling at a discount with its lower coupon rate of 6%. Bond X's current yield is 18%, and Bond Y's is 3%. Bond X has a higher credit risk while Bond Y carries liquidity risk, both affecting the required return.

Step-by-step explanation:

Given the current yield to maturity (YTM) of 8%, Bond X, with its high coupon rate of 18%, is likely selling at a premium, because its coupon rate is significantly higher than the YTM. This means investors can get higher interest payments from Bond X compared to newer bonds with a YTM of 8%. In contrast, Bond Y, with a coupon rate of 6%, is likely selling at a discount, as its coupon rate is lower than the YTM, making it less attractive, unless it is priced below par value to compensate for the lower interest payments.

For the calculation of current yield, divide the annual interest payment by the bond's current price. Bond X's current yield is 18% as it pays $180 annually ($1,000 * 18%) and assuming it's priced at $1,000. Bond Y's current yield is 3%, as it pays $30 semi-annually ($1,000 * 6% / 2).

Risk premiums for Bond X include the credit risk premium, as the poor rating suggests a higher risk of default, leading to a demand for higher returns to compensate for this risk. Bond Y likely carries a liquidity risk premium, due to its active trading on the secondary market, which implies variability in price that investors need to be compensated for.