ABC plc plans to issue bonds with a face value of £10,000 each, coupon rate of 4 percent, paid annually, and 10 years to maturity. The current market interest rate on similar bonds is 4 percent. In one years’ time, the long-term interest rate for this type of bond is predicted to be either 5 percent or 3 percent with equal probability. Assume investors are risk-neutral.
a. If the bonds are non-callable, what is the price of the bonds today, taking into account only the current market interest rate on similar bonds? Explain your answer
b. If the bonds are non-callable, what is the price of the bonds today, taking into account both the current market interest rates and the long-term interest rates after one year?
c. What is the current yield of the bond for a bondholder based on the value you computed in (b) above?
d. If the bonds are callable one year from today at 110 per cent of the face value, will their price be greater than or less than the price you computed in (b)? Explain your answer
e. Why would a firm choose to issue callable bonds?
f. In an efficient market, would callable bonds be priced higher or lower than the non-callable bonds, other things being equal? Explain your answer.
g. Why do investors pay attention to bond ratings and demand a higher interest rate for bonds with lower rating? What does lower rating imply in terms of credit risk?