Question

As part of your analysis of debt issued by Monticello Corporation, you are asked to evaluate two specific bond issues, shown in the table below:

Monticello Corporation Bond Information

Coupon	Bond A (Callable)	Bond B (Non-callable)
Maturity	2019	2019
Coupon	11.50%	7.25%
Current Price	125.75	100.00
Yield to Maturity	7.70%	7.25%
Modified duration to maturity	6.20	6.80
Call Date	2013	----
Call Price	105	-----
Yield to Call	5.10%	-----
Modified duration to call	3.10	------

a. Using the duration and yield information in the table, compare the price and yield behavior of the two bonds under each of the following two scenarios:

i. Strong economic recovery with rising inflation expectations.

ii. Economic recession with reduced inflation expectations.

b. Using the information in the table, calculate the projected price change for bond B if the yield-to-maturity for this bond falls by 75 basis points.

c. Describe the shortcoming of analyzing bond A strictly to call or to maturity.

Short answer

a. (i) Interest rates and bond yields will rise, and the prices of both bonds will fall

(ii) Interest rates and bond yields will fall

b. $105.10.

c. Uncertain bond life and cash flow, long durations and high yields, distorted calculations for yield and duration.

Step-by-step solution

Comparison of price-yield behavior in different scenarios

(i) In this scenario, it is very likely that Interest rates and bond yields will rise, and the prices of both bonds will fall. It will also lessen the probability of the callable bond is called.

(ii) In this scenario, it is very likely that Interest rates and bond yields will fall. The lower duration indicates that its price appreciation is limited. On the other hand, the non-callable bond has the same modified duration and hence the greater price appreciation.

Calculation of projected price change for Bond B

Since the YTM on Bond B has fallen by 75 basis points:

Projected price change = (modified duration) x (change in YTM)

= (–6.80) x (–0.75%)

= 5.1%

So the approximate price rises up to $105.10.

Explanation of the shortcoming of analyzing bond A

There are several shortcomings:

(i) Its bond life and bond cash flows are uncertain.

(ii) Durations are too long and yields are too high but it is unrealistically short and yields too low if it is sold above the call price.

(iii) On ignoring the call feature and analyzing the bond, all calculations for yield and duration are distorted.