Case Scenario:
Stephanie is an investor who is willing and able to bear substantial risk in order to earn a higher return. As her financial planner, you believe that high-yield debt instruments would be an attractive alternative to stocks, whose prices have risen recently. High-yield securities offer larger returns but may involve substantial risk. The combination of high risk and high return are consistent with her investment philosophy so you suggest the following B-rated bonds:
Maturity Date Yield to
Company Coupon (Years) Price Maturity
A 10% 10 $900 11.75%
B 15% 15 1,200 12.055
C 0 7 487 10.825
D 7 10 772 10.847
In addition, she also wants you to compare the bonds' price volatility with the triple-A rated bonds with the same terms to maturity. The four triple-A rated bonds are as follows:
Maturity Date Yield to
Company Coupon (Years) Price Maturity
E 6.5% 10 $900 7.99%
F 10.5% 15 1,200 8.143
G 0 7 587 7.908
H 4.5 10 772 7.879
Questions:
1. If interest rises by 3 percent across the board, what will be the new price of each of the eight bonds?
2. What do these new prices suggest about the price volatility of high-yield versus high quality bonds?
3. Which bond prices were more volatile?
4. If two bonds with the same term to maturity sell for the same price, which bond may subject the investor to more interest rate risk?
5. Does acquiring bonds with higher credit ratings and less default risk also imply the investor has less interest rate risk?