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Interpreting Bond Yields [LO2] Suppose you buy a 7 percent coupon, 20-year bond today when it's first issued. If interest rates suddenly rise to 15 percent, what happens to the value of your bond? Why?
"Price and yield move in opposite directions; if interest rates rise, the price of the bond will fall. This is because the fixed coupon payments determined by the fixed coupon rate are not as valuable when interest rates rise—hence, the price of the bond decreases."
Interpreting Bond Yields [LO1] Is the yield to maturity on a bond the same thing as the required return? Is YTM the same thing as the coupon rate? Suppose today a 10 percent coupon bond sells at par. Two years from now, the required return on the same bond is 8 percent. What is the coupon rate on the bond then? The YTM?
"The yield to maturity is the required rate of return on a bond expressed as a nominal annual interest rate. For noncallable bonds, the yield to maturity and required rate of return are interchangeable terms. "Unlike YTM and required return, the coupon rate is not a return used as the interest rate in bond cash flow valuation, but is a fixed percentage of par over the life of the bond used to set the coupon payment amount. ""The coupon rate is constant at 10% . The YTM is 8%.
Inflation and Nominal Returns [LO4] Suppose the real rate is 2.1 percent and the inflation rate is 3.4 percent. What rate would you expect to see on a Treasury bill?
(1+real rate)=(1+nominal rate)/(1+inflation rate) (1+0.021)=(1+nominal rate)/(1+0.034) nominal rate=(1.021*1.034)-1 =5.57%(Approx).
Nominal and Real Returns [LO4] An investment offers a total return of 12.3 percent over the coming year. Janice Yellen thinks the total real return on this investment will be only 8 percent. What does Janice believe the inflation rate will be over the next year?
(1+real rate)=(1+nominal rate)/(1+inflation rate) (1+0.08)=(1+0.123)/(1+inflation rate) 1+inflation rate=(1.123/1.08) inflation rate=(1.123/1.08)-1 =3.98%(Approx).
A corporation has issued both common and preferred stocks. Can the corporation make payments to common stockholders, even if it is missing the dividend due to preferred stockholders?
. No, the corporation must pay preferred stockholders before common stockholders
Why is it that municipal bonds are not taxed at the federal level, but are taxable across state lines? Why are U.S. Treasury bonds not taxable at the state level? (You may need to dust off the history books for this one.) Rating Agencies [LO3] A controversy erupted regarding bond-rating agencies when some agencies began to provide unsolicited bond ratings. Why do you think this is controversial?
As a general constitutional principle, the federal government cannot tax the states without their consentif doing so would interfere with state government functions. At one time, this principle was thoughtto provide for the tax-exempt status of municipal interest payments. However, modern court rulingsmake it clear that Congress can revoke the municipal exemption, so the only basis now appears to behistorical precedent. The fact that the states and the federal government do not tax each other'ssecurities is referred to as "reciprocal immunity."
How does a bond issuer decide on the appropriate coupon rate to set on its bonds? Explain the difference between the coupon rate and the required return on a bond.
Bond issuers look at outstanding bonds of similar maturity and risk. The yields on such bonds are usedto establish the coupon rate necessary for a particular issue to initially sell for par value. Bond issuers also ask potential purchasers what coupon rate would be necessary to attract them. The coupon rate isfixed and determines what the bond's coupon payments will be. The required return is what investors actually demand on the issue, and it will fluctuate through time. The coupon rate and required return are equal only if the bond sells for exactly par.
Looking back at the crossover bonds we discussed in the chapter, why do you think split ratings such as these occur?
Bond ratings have a subjective factor to them. Split ratings reflect a difference of opinion among credit agencies
A Japanese company has a bond outstanding that sells for 105.43 percent of its ¥100,000 par value. The bond has a coupon rate of 3.4 percent paid annually and matures in 16 years. What is the yield to maturity of this bond?
Current value=100,000*105.43%=105430 Annual coupon=100,000*3.4%=3400 Hence approx Yield to maturity=[Annual coupon+(Face value-Current value)/time to maturity]/(Face value+Current value)/2 =[3400+(100,000-105430)/16]/(100,000+105430)/2 which is equal to =2.97%(Approx).
Using Treasury Quotes [LO2] Locate the Treasury bond in Figure 7.4 maturing in February 2040. Is this a premium or a discount bond? What is its current yield? What is its yield to maturity? What is the bid-ask spread in dollars? Assume a par value of $10,000.
It is a premium bond because its price is higher than its face value a] Current yield = annual coupon / price For price, we use the ask price because that is the price to purchase the bond today. Current yield = 4.625 / 129.7813 Current yield = 3.564% b] YTM = asked yield. This is because asked yield is the YTM based on the asked price, which is the price to purchase the bond today. YTM = 2.855% c] bid-ask spread in dollars = (ask price - bid price) * par value bid-ask spread in dollars = (129.7813 - 129.7188) * $10,000 bid-ask spread in dollars = $625.00
Using Treasury Quotes [LO2] Locate the Treasury issue in Figure 7.4 maturing in May 2038. What is its coupon rate? What is its bid price? What was the previous day's asked price? Assume a par value of $10,000.
May 2038 corresponds to 5/15/2038Coupon rate=4.5Bid=128.0625Ask=128.125Change=0.6875Asked yield=2.749 1.=4.50% 2.=128.0625%*10000=12806.25 3.=(128.125-0.6875)/100*10000=12743.75
You find a zero coupon bond with a par value of $10,000 and 17 years to maturity. If the yield to maturity on this bond is 4.2 percent, what is the price of the bond? Assume semiannual compounding periods.
N = 17x2=34 I/Y =4.2/2=0.021 PMT = 0FV = $10,000PV = $4,933
Is it true that a U.S. Treasury security is risk-free?
No. As interest rates fluctuate, the value of a Treasury security will fluctuate. Long-term Treasury securities have substantial interest rate risk.
With regard to bid and ask prices on a Treasury bond, is it possible for the bid price to be higher? Why or why not?
No. If the bid were higher than the ask, the implication would be that a dealer was willing to sell a bond and immediately buy it back at a higher price. How many such transactions would you like to do?
Gabriele Enterprises has bonds on the market making annual payments, with eight years to maturity, a par value of $1,000, and selling for $948. At this price, the bonds yield 5.1 percent. What must the coupon rate be on the bonds?
PMT(5.1%,8,-948,1000)
Treasury bid and ask quotes are sometimes given in terms of yields, so there would be a bid yield and an ask yield. Which do you think would be larger? Explain.
Prices and yields move in opposite directions. Since the bid price must be lower, the bid yield must be higher.
Weismann Co. issued 15-year bonds a year ago at a coupon rate of 4.9 percent. The bonds make semiannual payments and have a par value of $1,000. If the YTM on these bonds is 4.5 percent, what is the current bond price?
Since Weismann Co. issued 15-year bonds a year ago so life remaining = 14 years Coupon rate semi annual = 4.9% / 2 = 2.45% , periods = 2 * 14 = 28 Current Bond price = semi annual coupon payment * PVAF(2.25%, 28 periods) + FV * PVF(2.25%, 28 periods) Current bond price = $24.5 * 20.60782764 + 1000 * 0.536323878 = $1041.22
What is the US Treasuries yield curve
The US Treasuries yield curve is just a graphical representation of the US Treasuries term structure. The term structure just shows the relationship between maturity and yields for US Treasuries.
If a corporation fails to pay the fixed dividends due to preferred stock holders, it might go bankrupt. Is the statement true or false? Why?
The statement is false. The preferred stockholders must be paid before the common stockholders. However, dividend payments (both preferred and common) are not a liability. Thus, the corporation can just decide to not pay preferred dividends.
A company is contemplating a long-term bond issue. It is debating whether to include a call provision. What are the benefits to the company from including a call provision? What are the costs? How do these answers change for a put provision?
There are two benefits. First, the company can take advantage of interest rate declines by calling in anissue and replacing it with a lower coupon issue. Second, a company might wish to eliminate a covenant for some reason. Calling the issue does this. The cost to the company is a higher coupon. A put provision is desirable from an investor's standpoint, so it helps the company by reducing thecoupon rate on the bond. The cost to the company is that it may have to buy back the bond at an unattractive price.
West Corp. issued 25-year bonds two years ago at a coupon rate of 5.3 percent. The bonds make semiannual payments. If these bonds currently sell for 105 percent of par value, what is the YTM?
Using finanncial calculator:N=23*2=46PV=-105%*100=-105PMT=5.3%*100/2=2.65FV=100CPT I/Y=2.467% Hence, ytm=2*2.467%=4.9340%
Are there any circumstances under which an investor might be more concerned about the nominal return on an investment than the real return?
Yes. Some investors have obligations that are denominated in dollars; i.e., they are nominal. Their primary concern is that an investment provides the needed nominal dollar amounts. Pension funds, for example, often must plan for pension payments many years in the future. If those payments are fixed in dollar terms, then it is the nominal return on an investment that is important.
Bond Price Movements [LO2] Bond X is a premium bond making semiannual payments. The bond pays a coupon rate of 7.4 percent, has a YTM of 6.8 percent, and has 13 years to maturity. Bond Y is a discount bond making semiannual payments. This bond pays a coupon rate of 6.8 percent, has a YTM of 7.4 percent, and also has 13 years to maturity. a) What is the price of each bond today?b) If interest rates remain unchanged, what do you expect the price of these bonds to be one year from now? In three years? In eight years? In 12 years? In 13 years? c)What's going on here? Illustrate your answers by graphing bond prices versus time to maturity.
a)Semi-annual Present ValueN = 26i/YR = 3.40%PMT = (7.40% x 1,000) / 2 = 37FV = 1,000PV = $,1051.24 ONE Year Semi-annual Present ValueN = 24i/YR = 3.40%PMT = (7.40% x 1,000) / 2 = 37FV = 1,000PV = $,1048.69 3y.Semi-annual Present ValueN = 20i/YR = 3.40%PMT = (7.40% x 1,000) / 2 = 37FV = 1,000PV = $1,043.03 8y. Semi-annual Present ValueN = 20i/YR = 3.40%PMT = (7.40% x 1,000) / 2 = 37FV = 1,000PV = $1,025.08 12y. Semi-annual Present ValueN = 2i/YR = 3.40%PMT = (7.40% x 1,000) / 2 = 37FV = 1,000PV = $1,005.71 13y Semi-annual Present ValueN = 0i/YR = 3.40%PMT = (7.40% x 1,000) / 2 = 37FV = 1,000PV = $1,000 c)
McConnell Corporation has bonds on the market with 14.5 years to maturity, a YTM of 5.3 percent, a par value of $1,000, and a current price of $1,045. The bonds make semiannual payments. What must the coupon rate be on these bonds?
take YTM times by 2 14.5 times 2=29=t =PMT(0.0265,29,-1045,1000,) =$28.74 for semi x2= 5.75
Which has greater interest rate risk, a 30-year Treasury bond or a 30-year BB corporate bond?
the Treasury security will have lower coupons because of its lower default risk, so it will have greater interest rate risk
Valuing Bonds [LO2] Even though most corporate bonds in the United States make coupon payments semiannually, bonds issued elsewhere often have annual coupon payments. Suppose a German company issues a bond with a par value of €1,000, 23 years to maturity, and a coupon rate of 3.8 percent paid annually. If the yield to maturity is 4.7 percent, what is the current price of the bond?
enter:=PV(0.047,23,58,1000) on excel