Question

Bond A: T-bills (153 days to maturity)

Bond B: TIPS (7 years to maturity)

Bond C: T-bonds (7 years to maturity)

Bond D: Callable bond (18 years to maturity)

Bond E: Corporate bond (3 years to maturity; YTM 9%)

Bond F: Munis (3 years to maturity; YTM 7%)

(a) The current price of Bond A is $974.6, what is its discount yield?

(b) If you believe that the inflation will rise a lot in the future, is Bond B or C a better investment choice? Explain briefly.

(c) Bond D is callable in 10 years with call premium of 5%. Explain what it means, and a typical situation that the bond will be called.

(d) Bond E has just been downgraded by S&P. Discuss how the supply and/or demand curves of the bond and its yield be affected.

(e) If you are indifferent between Bond E and Bond F, what is the marginal tax rate?

Answer 1

Solution:

a)Calculation of discount yield(Assuming 360 days in a year)

Discount yield=[(Face Value-Price of bond)/Face value]*360/days to maturity

=[($1000-$974.6)/$1000]*360/153

=0.0254*360/153

=0.061 or 6.10%

b)TIPS(Treasury Inflation-Protected security) is a treasury bond that is indexed to an inflationery gauge to protect investors from the decline in the purchasing power of their money.As inflation rises,TIPS adjust in price to maintain its real value.

The above feature is not availble with T-bonds.

Since Bond B is TIPS,hence Bond B is a better investment choice.

c)Callable bond is a type of bond that provides the borrower(Issuer of the bond) with the right,but not an obligation,to redeem the bond before its maturity date.It allows the issuing comapny to pay off their debt early.

A company may choose to call their bonds if market interest rate move lower,which will allow the to reborrow at a more beneficial rate.

Call premium is dollar amount above the par value of callable bond.Thus if you say that,bond is callable in 10 years with call premium of 5%,it means that the bond can be redeem by the issuer in 10 years at a price of 105% of par value of bond.

d)A bond credit rating is an assessment of its issuer's laiblity to repay its debts.A downgrade occurs when the credit rating is lowered.Thus when there is increase in the risk regarding repayment of bond,then the investor who hold the bond would like to sell the bond,consequently the supply is increases.Thus supply curve will shift to right.

Demand will decrease with increase in risk.Accordingly,the demand curve will shipt to left.

When the bond is downgraded  its yield will be significantly increases.