Fixed Income BMC module. When investors doubt the creditworthiness of a borrower, what should happen to the price and yield of the bond?
O Price goes up, yields go up
O Price goes down, yields go up
O Price goes down, yields go down
O Price stays the same, yields go down
O Price goes up, yields go down
The correct answer and explanation is:
Correct Answer: Price goes down, yields go up
When investors doubt the creditworthiness of a borrower, the price of the bond typically decreases, and the yield increases. Here’s why:
Bond Pricing Basics
A bond’s price and yield have an inverse relationship. Yield refers to the return an investor earns from holding the bond, expressed as a percentage of its current market price. When the price of the bond falls, the yield rises because the bond’s fixed interest payments (coupon payments) become a larger percentage of its lower price.
Impact of Creditworthiness Doubts
- Increased Perceived Risk: If investors begin to doubt the creditworthiness of the bond issuer, they perceive a higher risk of default (failure to repay interest or principal). As a result, demand for the bond decreases because investors require compensation for taking on this higher risk.
- Price Declines: The decreased demand for the bond pushes its market price lower. Bondholders may also sell the bond to avoid potential losses, further driving down the price.
- Yield Rises: Despite the price drop, the bond’s coupon payments remain fixed. This means that the lower the price of the bond, the higher the effective return (yield) an investor earns by buying the bond at the reduced price.
Practical Example
Imagine a bond with a face value of $1,000 and a 5% annual coupon rate, paying $50 annually. If the bond’s price falls to $800 due to credit concerns, the yield increases because the $50 annual coupon payment represents a larger return relative to the new price ($50/$800 = 6.25% yield).
Conclusion
Thus, when investors doubt the borrower’s creditworthiness, the bond’s price drops as investors demand higher compensation for the increased risk, causing the bond’s yield to rise. This relationship is fundamental to understanding how risk perceptions affect fixed-income securities.