Problem 4

Three years ago, you purchased a corporate bond with a par value of $100. This bond has an annual coupon rate of 8%, and the coupons are paid semiannually. You purchased the bond at the market price right after it made its coupon payment. At the time of the purchase, the bond’s YTM was 10%. A year ago, the bond was downgraded, and its YTM increased as a result. Right now you are considering selling this bond. There are exactly two years remaining to maturity with four semiannual coupons left to be paid. If you sell the bond now, you will realize the holding period (three-year) return of 27.767%.

(a) By how much did the bond’s YTM increase after the downgrade? Before the downgrade, the YTM remained constant. After the downgrade and the increase in YTM, the YTM also remained constant.

(b) What would your holding-period (three-year) return have been if there had not been a downgrade? What would be your effective annual rate of return?