Corporate Bond Trading: Premiums and Discounts

Reasons behind Bond Premiums and Discounts

When researching which corporate bonds to invest, you noted that some bonds were trading at a premium (e.g. 4.7% coupon bonds issued by BSD Ltd was trading at 5% above its par value), whereas some were trading at a discount (e.g. 5.25% coupon bonds issued by API Ltd was trading 2% below its par value). (a) Hypothesise four (4) reasons for your observations.  (b) Market data obtained from S&P Capital IQ is shown below: ? VMX Ltd has a beta of 1.3 and debt-to-equity ratio of 0.5 ? Yield on long-term Singapore government bonds = 3% ? Yield on AAA-rated corporate bonds = 5% ? Bond price issued by VMX Ltd = $1,150 (6% coupon, paid semiannually, expiring in 8 years) ? Inflation rate = 1% ? Market risk premium = 6% ? Corporate tax rate is 17%. Solve for VMX’s weighted average cost of capital. (c) VMX stock is currently trading at $25.80. Its most recent reported earnings per share was $1.20. Based on guidance provided by management at the recent investor’s conference, earnings are expected to grow at 20% per year for the next 3 years, and 3% thereafter. The estimated dividend pay-out ratio is 50% for the next 3 years and 75% thereafter. Verify whether VMX stock is correctly priced by the market. (d) The market value of EEL Ltd’s equity is $50 million and it has $5 million debt. Management intends to issue bonds $20 million worth of bonds and use the proceeds to repurchase some outstanding shares. Examine whether the value of EEL’s equity will increase or decrease under the following scenarios: (i) no corporate tax and no bankruptcy costs, (ii) corporate tax rate is 17% and no bankruptcy costs and (iii) corporate tax rate is 17% and with bankruptcy costs.