Question

You have received a $10,000 bonus from the company you work for and plan on investing that $10,000 into a bond maturing in 10 years. Interest earned on a bond is subject to a 28% federal income tax. The current interest rate is based upon a 10-year U.S. Treasury with a yield of 2.23% and interest rates are expected to remain stable over the ten-year period. You have the following options to choose from:

Option A: A $10,000 municipal bond that was originally a twenty-year issue. The bond is selling at a premium $11,650, earns an annual coupon of 6.5%, and matures in ten years.

Option B: A $10,000 corporate bond that was originally a fifteen-year issue. It is investment grade and is selling on a discount at $9,500 with an annual 3% coupon and matures in ten years.

Option C: A $10,000 new issue U.S. Treasury zero-coupon bond selling at par value. It matures in ten years and has a yield of 2.23%.

Option D: A $10,000 high-yield corporate bond selling at par value. It has ten years until maturity and earns an annual coupon of 7.93%.

Assume that the annual coupon is paid semi-annually. Based upon the above options, which bond, based on a strictly financial standpoint, should you invest your money in and why? Are there any other factors that may affect your decision? If so, explain.

Answer 1

Firstly , we need to calculate the Yield to maturity of these bonds

YTM= (C+ (F-P)/n)/(F+P/2)

C= coupon amount

F= face value

P= Price

N= tenor

Option A: C= 10000*6.5%= 650

            F= 10000

            P= 11650

            N=10

YTM=( 650+ (10000-11650)/10 )/(10000+11650)/2

= 485/10825

=0.0448 or 4.48%

Option B:

C= 10000*3%= 300

F= 10000

P= 9500

N=10

YTM=(300+ (10000-9500)/10 )/(10000+9500)/2

= 350/9750

=0.03589 or 3.59%

Option C: it’s a zero coupon bond

F= 10000

P= 10000

N=10

YTM= 2.23%

Option D:

C= 10000*7.93%= 793

F= 10000

P= 10000

N=10

YTM=(793+ (10000-10000)/10 )/(10000+10000)/2

= 793/10000

=0.0793 or 7.93%

Here we can see that option D has the greatest YTM, meaning this bonds give the highest return on the investment made and has the highest profit.

Do from financial point , option D is the best option.

But there are some other factors that are needed to be checked that affects the decision of bond selection.

1. Credit rating, the credit rating of the bonds can tell how the bond will perform and the risk of the bond, the rating will inform about the credibility of the bond.
2. Credibility of the issue, before issuing the bond one needs to understand the issuer of the bond and the potential of them paying back the money. The stability of the issuer and the financials of the company should be studied before making invetsing decisions.