Question

Cathy Moran, CFA, is estimating a value for an infrequently traded bond with six years to maturity, an annual coupon of 7%, and a single-B credit rating. Moran obtains yields-to-maturity for more liquid bonds with the same credit rating: • 5% coupon, eight years to maturity, yielding 7.20%. # 6.5% coupon, five years to maturity, yielding 6.40%.

The infrequently traded bond is most likely trading at:
A. par value.
B. a discount to par value.
C. a premium to par value.

Answer 1

Considering market yields and liquidity risk, the infrequently traded bond with a 7% annual coupon and a single-B credit rating is most likely trading at a discount to par value to offer an attractive yield equivalent to more liquid bonds of the same credit rating. Correct answer is option b.

Step-by-step explanation:

When assessing the potential trading value of a bond, one must consider the active market yields and the specifics of the bond in question. Cathy Moran, CFA, is comparing a bond with an annual coupon of 7% and a single-B credit rating to other bonds with the same credit rating but different coupon rates and maturities.

If we look at the market yields provided, the infrequently traded bond with a 7% coupon is compared to a liquid bond that has a 5% coupon but yields 7.20%, and another with a 6.5% coupon, yielding 6.40%. The 7% coupon rate on the infrequently traded bond is higher than the yield on a bond with closer to maturity (6.5% coupon bond yielding 6.40%), suggesting that our infrequently traded bond might trade at or above par if credit risk and maturity are the same.

However, considering that the bond in question is infrequently traded, thus possibly carrying higher risk and lower liquidity compared to the other bonds, and noticing the yield of 7.20% on the 5% coupon bond, suggests that the infrequently traded bond may require a higher yield to compensate for these risks. This would indicate that the bond would likely be trading at a discount to par value to match the market yield requirement of investors.

Understanding bond pricing dynamics and market comparisons is crucial. For a bond with a higher coupon than the yield of its peers in the market, there is a possibility it could trade at par or premium under normal circumstances. But considering liquidity risks and investor’s yield requirements, coupled with the insight that a bond with a lower coupon rate (5%) is currently yielding 7.20%, it can be strongly inferred that the infrequently traded bond might be trading below its face value to offer an attractive yield to investors.