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Corporate Bond Analysis and Valuation

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Corporate Bond Analysis and Valuation
Jill Dougherty was hired as an investment analyst by A.M. Smith Inc. for the Cincinnati, Ohio
office based on her sound academic credentials, which included an MBA from a top ranking
university and a CFA designation. At the time for her recruitment she was told that one of her
responsibilities would be to conduct educational seminars for current and prospective clients.
A.M. Smith Inc., a prestigious investment services firm, with branches in 30 major
metropolitan areas, had achieved most of its success due to its excellent client relations and focus
on client support. The firm ranked among the very best in terms of the number of successful
equity underwriting deals undertaken. Recently, a large utility company had hired it as the leading
investment banker for a major corporate bond issue. Since most of its retail customers were more
familiar with stock investment, John Sullivan, the branch manager at the Cincinnati office, asked
Jill to prepare and present a seminar outlining the various implications of fixed income
investments. "About 60% of our investors are in the 55+ age group, Jill, so we should not have
much trouble convincing them of the benefits of investing in bonds" remarked John. "However,
they may need clarifications regarding various terms and concepts associated with fixed income
investing. Your job is to convince them of the relative safety and income potential of corporate
bonds" said John.
In preparation for the seminar, Jill called up a few of her best clients and queried them
regarding their awareness of the risk and return potential associated with corporate bond
investments. She realized that apart from a good knowledge about the current level and stability
of interest rates and inflation, most customers were not very familiar about the finer aspects of
bond investing. Bond features like callability, convertibility, sinking fund provision, bond ratings,
debentures, interest rate risk, etc. were not well understood by most of the clients she interviewed.
Most of them seemed awfully interested in knowing more about the opportunities offered by bond
investing and Jill knew that she would have a good turnout at the seminar. She decided to refer
back to her Finance textbook and dig out some definitions and examples that she could use in her
PowerPoint presentation. She downloaded current data for outstanding bonds of various
maturities, ratings, and coupon rates (see Table 1) and started preparing her slides.
Table 1
Corporate Bond Information
Issuer Face
Rating Quoted
Years until
ABC Energy $1,000 5% AAA $703.1 20 Yes 3 Years
ABC Energy $1,000 0% AAA $208.3 20 Yes NA
TransPower $1,000 10% AA $1,092.0 20 Yes 5 Years
Telco Utilities $1,000 11% AA $1,206.4 30 No 5 Years
1. How should Jill go about explaining the relationship between coupon rates and bond prices?
Why do the coupon rates for the various bonds vary so much?
2. How are the ratings of these bonds determined? What happens when the bond ratings get
adjusted downwards?
3. During the presentation one of the clients is puzzled why some bonds sell for less than
their face value while others sell for a premium. She asks whether the discount bonds are a
bargain. How should Jill respond?
4. Jill knows that the call period and its implications will be of particular concern to the
audience. How should she go about explaining the effects of the call provision on bond
risk and return potential?
5. How should Jill go about explaining the riskiness of each bond? Rank the bonds in terms
of their relative riskiness.

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The solution explains various questions relating to bond analysis and valuation.

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1. How should Jill go about explaining the relationship between coupon rates and bond prices? Why do the coupon rates for the various bonds vary so much?

The relationship between coupon rates and bond prices is dependant on the current interest rate. At the time of issue if the coupon rate is the same as the market interest rate, then the price of the bond will be the same as the par value. As the market interest rates change, and the coupon interest remains the same, the prices change. If the market interest rate is higher than the coupon rate then the bond price will be lower than the par value. If the coupon interest rate is higher than the market interest rate, then the bond price will be higher than the par value.
The coupon rate is dependant on the maturity and the riskiness of the bonds. Two bonds with different maturities will have different coupon rates with the higher maturity bond having a higher rate as compared to the lower maturity bond. Two bonds with the same maturity, a more riskier bond (known from the bond rating) will have a higher coupon rate as compared to a less risky bond.

2. How are the ...

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