You are an investment banker who specializes in helping companies issue junk bonds. A client comes to you and wants to issue a coupon bond that matures in 5 years and makes semi-annual coupon payments. Currently, five-year coupon Treasury bonds have a yield to maturity of 2.1%. The coupons of the Treasury bonds are also paid semi-annually. Your client is rated BB, and credit spreads on BB bonds are 300 basis points (3%).
a. If your client wishes to price the bonds at par, at what rate should you set the coupon?
b. Suppose a trader buys the bond at par when it is issued, holds it for six months, receives a coupon at the end of the sixth month, and then sells the bond. In so doing, the trader earns a realized return of 5%. Assuming the bond has the coupon rate you set in part a), and the yield on the benchmark coupon Treasury mentioned above is now 2.2%, what is the corporate bond’s new credit spread? (Hint: first compute the new yield to maturity on the bond)
c. Do you think it is likely something happened to the bond’s credit rating? If so, what?