Question

Masters Corp. issues two bonds with 20-year maturities. Both bonds are callable at $1,050. The first bond is issued at a deep discount with a coupon rate of 4% and a price of $580 to yield 8.4%. The second bond is issued at par value with a coupon rate of 8.75%. a. What is the yield to maturity of the par bond and why? Why is it higher than the yield of the discount bond? b. If you expect rates to fall substantially in the next two years, which bond would prefer to hold?

I need a detailed answer for 10 marks

Answer 1

A. The yield to the maturity of the bond which is issued at par would be 8.75%, which is the coupon rate issued with the par value. It is higher than the yield of the discount bond because discount bond is yielding a lower rate of 8.4 %.

B. All else being equal,I will choose the coupon bond of 4% which should be more attractive because the coupon rate is far below the current market and its price is far below the calling price of the bond.

Therefore if the bond yields are going to fall the gains which should be capital gains in nature on the bond will not be limited by the call price of the bond.

In contrast, 8.75 % coupon bonds can increase upto the value of mostly 1050 so it is offering a maximum possible gain of only 5%. The disadvantage of 8.75% coupon bonds in terms of vulnerability to a call, is reflecting the higher promised yield of maturity so if the investor expect the rate to fall subsequently the 4% offerso a greater expected rate of return.

so if I am expecting the rate to fall subsequently next 2 years I will be selecting the bonds with the coupon rate of 4%.