A bond’s credit rating provides a guide to its risk. Suppose that long-term bonds rated Aa currently offer yields to maturity of 7.5%. A-rated bonds sell at yields of 7.8%. Suppose that a 10-year bond with a coupon rate of 7.6% is downgraded by Moody’s from an Aa to A rating.

A bond’s credit rating provides a guide to its risk. Suppose that long-term bonds rated Aa currently offer yields to maturity of 7.5%. A-rated bonds sell at yields of 7.8%. Suppose that a 10-year bond with a coupon rate of 7.6% is downgraded by Moody’s from an Aa to A rating.
a. Is the bond likely to sell above or below par value before the downgrade?
    Above par value
    Below par value

 Answer
Above par value

b. Is the bond likely to sell above or below par value after the downgrade?

    Above par value
    Below par value
Answer

Below par value

Explanation
 
Some values below may show as rounded for display purposes, though unrounded numbers should be used for actual calculations.

The bond’s yield to maturity will increase from 7.5% to 7.8% when the perceived default risk increases.  The bond price will fall:

a.
Initially, the bond is rated Aa and by that benchmark should yield around 7.5%. The coupon is 7.6%, so the bond price will be above par to offset the excess 0.1% coupon payment.

Initial price = PV=$77×[1.082−110.082(1.082)]+$1,00010(1.082)=$966.75


b.
After, the bond is rated A and by that benchmark should yield around 7.8%. The coupon is 7.6%, so the bond price will be below par to compensate for the insufficient coupon payment.

New price= PV=$77×[1.085−110.085(1.085)]+$1,00010(1.085)=$947.51