Question

The Portfolio entry should be a minimum of 250 words and not more than 750 words. Use APA citations and references if you use ideas from the readings or other sources. For this week’s portfolio activity, please advise the instructor of the following:

1. Utilizing the information provided in your course textbook(s) or other valid sources, briefly compare the coupon rate and the interest rate regarding bonds. What is a par value?

2. Describe the impact of a tax shield on fixed income yields.

3. Please provide a brief update to the instructor on how you feel you are doing so far this term.  

Answer 1

Utilizing the information provided in your course textbook(s) or other valid sources, briefly compare the coupon rate and the interest rate regarding bonds. What is a par value

A bond's coupon rate (sometimes abbreviated simply to "coupon") isn't affected by its price. However, the coupon rate influences the bond's price, by influencing the bond's competitiveness and value in the open market.

A bond's coupon rate denotes the amount of annual interest paid by the bond's issuer to the bondholder. Set when a bond is issued, coupon interest rates are determined as a percentage of the bond's par value, also known as the "face value." A $1,000 bond has a face value of $1,000. If its coupon rate is 1%, that means it pays $10 (1% of $1,000) a year.

Coupon rates are largely influenced by prevailing national government-controlled interest rates, as reflected in government-issued bonds (like the United States' U.S. Treasury bonds). This means that if the minimum interest rate is set at 5%, no new Treasuries may be issued with coupon rates below this level. However, preexisting bonds with coupon rates higher or lower than 5% may still be bought and sold on the secondary market.1

When new bonds are issued with higher interest rates, they are automatically more valuable to investors, because they pay more interest per year, compared to pre-existing bonds. Given the choice between two $1,000 bonds selling at the same price, where one pays 5% and the other pays 4%, the former is clearly the wiser option.

KEY TAKEAWAYS

• The coupon rate on a bond vis-a-vis prevailing market interest rates has a large impact on how bonds are priced.
• If a coupon is higher than the prevailing interest rate, the bond's price rises; if the coupon is lower, the bond's price falls.
• The majority of bonds boast fixed coupon rates that remain stable, regardless of the national interest rate or changes in the economic climate.
• A bond's current yield, however, is different: a percentage based on the coupon payment divided by the bond's price, it represents the bond's effective return.

Coupon Interest Rate vs. Yield

Most bonds have fixed coupon rates, meaning that no matter what the national interest rate may be—and regardless of market fluctuation—the annual coupon payments remain static.2 For instance, a bond with a $1,000 face value and a 5% coupon rate is going to pay $50 in interest, even if the bond price climbs to $2,000, or conversely drops to $500.

But if a bond's coupon rates are fixed, its yields are not. There are several types of bond yields, but one of the most relevant is the effective or current yield. Current yield is derived by dividing a bond's annual coupon payments—that is, the interest the bond is paying—by its current price. This calculation results in the actual return an investor realizes on that bond—its effective interest rate, in effect.2

Say that a $1,000 face value bond has a coupon interest rate of 5%. No matter what happens to the bond's price, the bondholder receives $50 that year from the issuer. However, if the bond price climbs from $1,000 to $1,500, the effective yield on that bond changes from 5% to 3.33%.

Conversely, If the bond price falls to $750, the effective yield is 6.67%.

General interest rates substantially impact stock investments. But this is no less true with bonds. When the prevailing market rate of interest is higher than the coupon rate—say there's a 7% interest rate and a bond coupon rate of just 5%—the price of the bond tends to drop on the open market because investors don't want to purchase a bond at face value and receive a 5% yield, when they could source other investments that yield 7%.

This drop in demand depresses the bond price towards an equilibrium 7% yield, which is roughly $715, in the case of a $1,000 face value bond. At $715, the bond's yield is competitive.

Conversely, a bond with a coupon rate that's higher than the market rate of interest tends to rise in price. If the general interest rate is 3% but the coupon is 5%, investors rush to purchase the bond, in order to snag a higher investment return. This increased demand causes bond prices to rise until the $1,000 face value bond sells for $1,666.

Other Impacts on Bond Prices

In reality, bondholders are as concerned with a bond's yield to maturity, especially on non-callable bonds such as U.S. Treasuries, as they are with current yield because bonds with shorter maturities tend to have smaller discounts or premiums.

The credit rating given to bonds also largely influences the price. It's possible that the bond's price does not accurately reflect the relationship between the coupon rate and other interest rates.

Because each bond returns its full par value to the bondholder upon maturity, investors can increase bonds' total yield by purchasing them at a below-par price, known as a discount. A $1,000 bond purchased for $800 generates coupon payments each year, but also yields a $200 profit upon maturity, unlike a bond purchased at par.

Describe the impact of a tax shield on fixed income yields.

A tax shield is a reduction in taxable income by taking allowable deductions. AccountingTools says that a tax shield is "the deliberate use of taxable expenses to offset taxable income." While tax shields are used for tax savings for both personal and business tax returns, this article focuses on tax shields for businesses.

What Are Some Examples of a Tax Shield?

Tax shields involve investments and purchases that are tax deductible. Some common examples include:

• Deductions for medical expenses for individuals. If expenditures on medical expenses are greater than the standard deduction, the excess expenses are tax deductible. If you are considering major surgery, for example, you might want to look at whether you want the tax shield in one year or another, to lower your taxable income.
• Charitable deductions for individuals and businesses. Charitable giving is a deductible expense for both individuals and businesses. For an individual to take a tax deduction on charitable giving, they must itemize deduction. Corporations can include charitable donations with some limits and restrictions.
• A mortgage is a classic tax shield for both individuals and businesses. Note that it's not the amount of the mortgage payment that's deductible; it's the interest expense.  
• Businesses can take a depreciation expense on the purchase of business property, including equipment, furniture and fixtures, and vehicles (but not land). Depreciation is basically a way to spread out the expense of buying a business asset over the life of that asset. Accelerated depreciation allows you to depreciate more of the asset in the first year or two, and it's a great example of a tax shield. The two types of accelerated depreciation are Section 179 expenses and bonus depreciation.

How Does a Tax Shield Save on Taxes?

Tax shields are part of an overall financial strategy. Look at it this way: As a person or a business, you can get tax deductions for certain types of purchases and activities. You can do this by accident, buying whatever you want whenever you want. Or you can save on taxes deliberately by planning purchases to take advantage of tax shields.

For example, a business is deciding whether to lease a building or to purchase the building. Taking on a mortgage for the purchase of a building would create a tax shield because mortgage interest is deductible. If the business puts the tax shield benefit from the mortgage into the decision, the tax benefit of a mortgage might make the decision easier.

What Are the Benefits of Tax Shields?

Tax shields are part of the overall financial strategy of businesses. Tax shields do the following:

• Increase expenses, though they lower taxable income.
• Decrease cash on hand, but they put money into investments that provide a higher return.

• For example, if you expect interest on a mortgage to be $1,200 for the year, and your tax rate is 20%, the amount of the tax shield would be $240. (Use these articles to find and calculate the corporate tax rate and personal tax rate for the current year.)

  As you review tax shields, compare the value of tax shields from one year to the next. If your business has a higher income and a higher tax rate in one year, the amount of tax savings will be higher in that year.

  How Does the New Tax Law Affect Tax Shields?

  The Trump Tax Cuts have several effects on tax shields. The main change is the reduction in income tax rates, beginning with 2018 taxes. The corporate tax rate has been reduced to a flat 21 percent, starting in 2018, and personal tax rates have also been reduced.

  Another big change is that the standard deduction on personal tax returns has been doubled, decreasing the value of some tax shields, like mortgage interest and charitable giving. Taxpayers won't be able to take advantage of these tax shields until they reach a level of deductions over the standard amount. Read more about the Trump Tax Plan and how it affects deductions.

  How to Take Advantage of Tax Shields

  The best way to maximize the tax-saving benefits of tax shields is to take the "tax shield effect" into consideration in all business financial decisions. Of course, tax savings shouldn't be the only consideration when you are planning your tax strategy for the year, but leaving tax shields out of the planning process can lower the value of your business and leave money on the table, so to speak.