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1. Assume that the bonds of highly leveraged ByHy corporation currently have a yield to maturity of 8% and are due to mature in 1 year. Meanwhile, assume that 1 year Treasury securities are yielding 1%. Also assume that investors expect that there is a 4% probability that ByHy corporation will default within the next year and that if it defaults they will only be able to recover 30% of the maturity value of the corporation's bonds.
a) Suppose that several prominent highly leveraged corporations (other than ByHy) default on their bonds. What would you expect to happen to the price of ByHy bonds and why?
b) Assume that after the news of defaults by other highly leveraged corporations, investors now expect an 8% probability of default and a recovery rate of only 20% in the event of default on ByHy's bonds. Also assume that increased uncertainty about the future of the high yield market has caused the required rate of return on ByHy's bonds to change to 10%. What will be the new yield to maturity on ByHy's bonds?
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