Spot yield rate (levante co – Dec 2011)

Levante Co has identified a new project for which it will need to increase its long-term borrowings from $250 million to $400 million. This amount will cover a significant proportion of the total cost of the project and the rest of the funds will come from cash held by the company.

The current $250 million borrowing is in the form of a 4% bond which is trading at $98•71 per $100 and is due to be redeemed at par in three years. The issued bond has a credit rating of AA. The new borrowing will also be raised in the form of a traded bond with a par value of $100 per unit.

It is anticipated that the new project will generate sufficient cash flows to be able to redeem the new bond at $100 par value per unit in five years. It can be assumed that coupons on both bonds are paid annually.

Both bonds would be ranked equally for payment in the event of default and the directors expect that as a result of the new issue, the credit rating for both bonds will fall to A. The directors are considering the following two alternative options when issuing the new bond:

(i) Issue the new bond at a fixed coupon of 5% but at a premium or discount, whichever is appropriate to ensure full take up of the bond; or
(ii) Issue the new bond at a coupon rate where the issue price of the new bond will be $100 per unit and equal to its par value.

The following extracts are provided on the current government bond yield curve and yield spreads for the sector in which Levante Co operates:

Current Government Bond Yield Curve
Year 1 2 3 4 5
3.2% 3.7% 4.2% 4.8% 5.0%
Yield spreads (in basis points)
Bond Rating 1 year 2 years 3 years 4 years 5 years
AAA 5 9 14 19 25
AA 16 22 30 40 47
A 65 76 87 100 112
BBB 102 121 142 167 193
Required:

Calculate the expected percentage fall in the market value of the existing bond if Levante Co’s bond credit rating falls from AA to A. (3 marks)

I’m facing trouble in understanding the calculation of spot yield rate, pls help me understand the spot yield rate based on A credit rating