Question

Please refer to the following list of bonds:

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

a) Discount yield calculates the investor's percent of return based on the bill's face value.

discount yield = (par value - purchase value)/par value * (360/days to maturity)

As per pur given question data is insufficient to calculate discount yield.

b) In such scenario, Bond B will be the better choice as its definition clearly defines its feature during inflation  (TIPS Treasury Inflation-Protected Securities (TIPS) are a form of U.S. Treasury bond designed to help investors protect against inflation. These bonds are indexed to inflation, have U.S. government backing, and pay investors a fixed interest rate as the bond's par value adjusts with the inflation rate.)

c) A callable bond (also called redeemable bond) is a type of bond (debt security) that allows the issuer of the bond to retain the privilege of redeeming the bond at some point before the bond reaches its date of maturity.

The call price will usually exceed the par or issue price. In certain cases, mainly in the high-yield debt market, there can be a substantial call premium.

d) If bonds are downgraded (that is, if the credit rating is lowered), the bond price declines. If the rating is upgraded, the price goes up. ... It would not result in a serious deterioration in the price of the bond.

e) In such case would chose Bond F as MUNIS, a shortened name for municipal bonds, which are bonds issued by cities and states to finance the government's expenses. Investors in munis don't have to pay federal income taxes on the bonds and are sometimes exempt from state and local taxes as well.