Question

A $2,800 face value corporate bond with a 6.7 percent coupon (paid semiannually) has 10 years left to maturity. It has had a credit rating of BBB and a yield to maturity of 7.2 percent. The firm has recently gotten into some trouble and the rating agency is downgrading the bonds to BB. The new appropriate discount rate will be 8.7 percent. What will be the change in the bond’s price in dollars and percentage terms?

Answer 1

The downgrade of a bond's credit rating increases its yield to maturity and decreases its price due to a higher discount rate reflecting escalated risk. The change in a $2,800 face value corporate bond's price due to a credit downgrade can be determined by recalculating its present value using the new discount rate, despite not having exact figures in this provided context.

Step-by-step explanation:

When a corporate bond's credit rating is downgraded, the market demands a higher yield to maturity to compensate for the added risk; this causes the bond price to fall.

For a $2,800 bond with a 6.7% coupon (paid semiannually) and 10 years left to maturity, originally discounted at 7.2% and now at 8.7% due to a credit downgrade, we can use the present value of annuities and a single lump sum to determine the change in price.

First, calculate the present value of the semiannual coupon payments and the bond's face value at the original discount rate, then recalculate at the new rate. The price difference (in dollars and percentage) will provide the desired information.

Unfortunately, without specific present value calculations, we can't give exact numbers. However, the bond price will certainly decrease, both because the discount rate increases and due to the perception of higher risk inherent in the lower credit rating.