Chapter 6, Solutions

Cornett, Adair, and Nofsinger

CHAPTER 6 Valuing Bonds Questions LG1 1. What does a call provision allow the issuer to do, and why would they do it? A call provision on a bond issue allows the issuer to pay off the bond debt early at a cost of the principal plus any call pre iu . !ost of the ti e a bond issuer is called, it is because interest rates have substantially declined in the econo y. "he issuer calls the e#istin$ bonds and issues new bonds at the lower interest rate. "his reduces the interest pay ents the issuer ust pay each year. LG% %. List the differences between the new "&'S and traditional "reasury bonds. "raditional "reasury bonds have a fi#ed principal and constant pay ents. (ecause the principal and coupon rate are fi#ed, interest rate chan$es in the econo y cause the ar)et price of the bonds to have lar$e fluctuations. *n the other hand, the principal of a "&'S increases with the rate of inflation. Si ilar to a "+bond, the "&'S has a constant coupon rate. ,owever, since the principal of the "&'S increases over ti e, the interest pay ent increases over ti e. "his inflation rate ad-ust ent of a "&'S. principal every si# onths reduces the a ount of downward price chan$e in the price of the bond when interest rates increase. LG% /. 0#plain how ort$a$e+bac)ed securities wor).

A lar$e a ount of ho e ort$a$es are purchased and pooled to$ether. "he ho e owners pay interest and principal onthly on their ort$a$es. (onds are issued fro the pool of ort$a$es, usin$ the ort$a$es as collateral. "he interest pay ents and bond principal pay ents for these ort$a$e+bac)ed securities 1!(S2 ori$inate fro the ort$a$e borrowers and flow throu$h the pool of ort$a$es. As the ho e owners pay off their ort$a$es over ti e, the !(S are also paid. LG/ 3. 'rovide the definitions of a discount bond and a pre iu bond. Give e#a ples.

A discount bond is si ply a bond that is sellin$ below its par value. &t would be 4uoted at a price that is less than 155 percent of par, li)e 66.57. A pre iu bond is a bond sellin$ above its par value. &ts price will be 4uoted as over 155 percent of par value, li)e 151.17. A bond beco es a discount bond when ar)et interest rates rise above the bond.s coupon rate. A bond beco es a pre iu bond when ar)et interest rates fall below the bond.s coupon rate. LG3 7. 8escribe the differences in interest pay ents and bond price between a 7 percent coupon bond and a 9ero coupon bond.

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Chapter 6, Solutions

Cornett, Adair, and Nofsinger

"he 7 percent coupon bond pays annual interest of 7 percent of the bond.s par value. ;or <1,555 par value bond, this would be <75 per year. "his interest i$ht be paid in two pay ents of <%7. "he price of the coupon bond tends to stay near its par value. "he 9ero coupon bond pays no interest pay ents. "he bondholder earns a return fro the increase of the bond.s ar)et price over ti e. "he bond.s price is initially uch lower than its par value. When the 9ero coupon bond finally atures, the par value is paid. LG7 6. All else e4ual, which bond.s price is ore affected by a chan$e in interest rates, a short+ter bond or a lon$er+ter bond? Why? All else e4ual, a lon$+ter bond e#periences lar$er price chan$es when interest rates chan$e than a short+ter bond. A bond.s price is the present value of all its cash flows. Chan$es in the discount rate 1the interest rate2 i pact present values ore for cash flows that are further out in ti e. LG7 :. All else e4ual, which bond.s price is ore effected by a chan$e in interest rates, a bond with a lar$e coupon or a s all coupon? Why? "he price of the bond with the s all coupon will be i pacted ore by a chan$e in interest rates than the price of the lar$e coupon bond. ;or a s all coupon bond, the cash flows are wei$hted uch ore toward the aturity date because of the s all interest pay ents. "he lar$e coupon bond has hi$h interest pay ents, any occur soon. "hese hi$her cash flows ade earlier da pen the i pact of interest rate chan$es because those chan$es in the discount rate i pact the earlier cash flows to a lesser de$ree than the later cash flows. LG7 =. 0#plain how a bond.s interest rate can chan$e over ti e even if interest rates in the econo y do not chan$e. (ecause of the yield curve, there are different interest rates that apply to each ti e to aturity. So, as a bond $ets closer to its aturity date, different interest rates ay apply to its discountin$ even when interest rates in the econo y have not chan$ed. LG6 6. Co pare and contrast the advanta$es and disadvanta$es of the current yield co putation versus yield to aturity calculations. "he current yield co putation is useful because it is a very si ple one. &t provides a 4uic) and easy assess ent of what the bond offers the investor in return. (ut it easures only the return fro the interest rate pay ents. "he full return to an investor also includes the capital $ain or loss the bond will e#perience if it is sellin$ as a discount or pre iu bond. "he yield to aturity co putation is ore difficult, but it incorporates the full return the bond offers to investors. LG6 15. What is the yield to call and why is it i portant to a bond investor?

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Chapter 6, Solutions

Cornett, Adair, and Nofsinger

!any bonds do not survive until their aturity date because they $et paid early throu$h a call provision. "he yield to call is the yield that would be earned if the bond is purchased at today.s price and held until it is called by the issuer. "he co putation incorporates the additional call pre iu that is paid with the principal. LG6 11. What is the purpose of co putin$ the e4uivalent ta#able yield of a unicipal bond?

!unicipal bonds offer a ta# advanta$e for the bondholder that other )inds of bonds do not offer. "hus, their yield to aturity is not directly co parable to that of other bonds. "he e4uivalent ta#able yield 10">2 is an ad-ust ent to the yield to a)e it co parable to ta#able bonds. (ond investors can use the 0"> to assess which bond will earn the a hi$her after+ta# return. LG6 1%. 0#plain why hi$h inco e and wealthy people are than a corporate bond. ore li)ely to buy a unicipal bond

&ndividual bondholders do not owe ta#es on interest pay ents received fro unicipal bonds. "his ta# advanta$e is ore valuable to individuals who are in a hi$her ar$inal ta# brac)et. (ecause wealth individuals are usually in a hi$her ta# brac)et, this ta# advanta$e is ore valuable to the . LG: 1/. Why does a "reasury bond offer a lower yield than a corporate bond with the sa e ti e to aturity? Could a corporate bond with a different ti e to aturity offer a lower yield? 0#plain. "he "reasury bond has lower credit ris) than the corporate bond. Given the ris)?return relationship, lower ris) is associated with lower e#pected return. "hus, all else e4ual, a "reasury bond will offer a lower yield to aturity than a corporate bond. ,owever, if the yield curve slopes upward, then shorter ter to aturity bonds will re4uire a s aller interest rate than lon$er ter bonds. So, it is possible that a short+ter corporate bond would offer a lower yield than a lon$+ter "reasury bond. LG: 13. 8escribe the difference between a bond issued as a hi$h+yield bond and one that has beco e a @fallen an$el.A (oth of these bonds would be rated as (( or below. "he co pany referred to as a fallen an$el would be a fir that was a successful, financially stable fir that has recently stru$$led. !any of the bondholders had purchased the bond when it was rated uch better. "he other co pany issued bonds when it was already in a less financially stable condition. "he purchasers of these bonds bou$ht the bonds while they were rated as a -un) bond. LG= 17. What is the difference in the tradin$ volu e between "reasury bonds and corporate bonds? Give e#a ples and?or evidence.

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Chapter 6, Solutions

Cornett, Adair, and Nofsinger

"here is hi$h tradin$ volu e in "reasury bonds and low volu e in corporate bonds. LG= 16. 0#plain how the Leh an (rothers &nter ediate (ond &nde# i$ht increase one day while the !errill Lynch ,i$h >ield &nde# decreases the sa e day. "hese two indices use different bonds. "his Leh an inde# uses "reasury bonds with ediu ter s to aturity. "he !errill Lynch inde# uses hi$h ris) bonds. When investors deter ine that there is ore ris) in the econo y, the spread between the safer bonds 1"reasuries2 and ris)ier bonds 1hi$h yield2 widen. &f ris) in the econo y is perceived to be declinin$, this spread will decrease. "his 4uestion is an e#a ple of the spread widenin$. Problems (asic 'roble s LG1 6+1 Interest Payments 8eter ine the interest pay ent for the followin$ three bondsB / C percent coupon corporate bond 1paid se i+annually2, 3.%7 percent coupon "reasury note, and a corporate 9ero coupon bond aturin$ in 15 years. 1Assu e a <1,555 par value.2 / C percent coupon corporate bond 1paid se i+annually2B C D /.7E D <1,555 F <1:.75 3.%7 percent coupon "reasury noteB C D 3.%7E D <1,555 F <%1.%7 corporate 9ero coupon bond aturin$ in 15 yearsB 5E D <1,555 F <5 LG1 6+% Interest Payments 8eter ine the interest pay ent for the followin$ three bondsB 3 C percent coupon corporate bond 1paid se i+annually2, 7.17 percent coupon "reasury note, and a corporate 9ero coupon bond aturin$ in 17 years. 1Assu e a <1,555 par value.2 3 C percent coupon corporate bond 1paid se i+annually2B C D 3.7E D <1,555 F <%%.75 7.17 percent coupon "reasury noteB C D 7.17E D <1,555 F <%7.:7 corporate 9ero coupon bond aturin$ in 15 yearsB 5E D <1,555 F <5 LG1 6+/ Time to Maturity A bond issued by ;ord on !ay 17, 166: is scheduled to ature on !ay 17, %56:. &f today is Gove ber 16, %55=, what is this bond.s ti e to aturity? !ay 17, %56: LG1 inus Gove ber 16, %55= F == years and 6 onths

6+3 Time to Maturity A bond issued by &(! on 8ece ber 1, 1666 is scheduled to ature on 8ece ber 1, %566. &f today is 8ece ber %, %55:, what is this bond.s ti e to aturity? 8ece ber 1, %566 inus 8ece ber %, %55: F =6 years

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Chapter 6, Solutions

Cornett, Adair, and Nofsinger

LG1

6+7 Call Premium A : percent corporate coupon bond is callable in five years for a call pre iu of one year of coupon pay ents. Assu in$ a par value of <1,555, what is the price paid to the bondholder if the issuer calls the bond? principal H call pre iu F <1,555 H :ED<1,555 F <1,5:5

LG1

6+6 Call Premium A 6.7 percent corporate coupon bond is callable in ten years for a call pre iu of one year of coupon pay ents. Assu in$ a par value of <1,555, what is the price paid to the bondholder if the issuer calls the bond? principal H call pre iu F <1,555 H 6.7ED<1,555 F <1,567

LG%

6+: TIPS Interest and Par Value A % I percent "&'S has an ori$inal reference C'& of 1=7.3. &f the current C'& is %15.:, what is the current interest pay ent and par value of the "&'S? par value F %15.:?1=7.3 D <1,555 F <1,1/6.36 interest pay ent F C D %.:7E D <1,1/6.36 F <17.6/

LG%

6+= TIPS Interest and Par Value A / 1?= percent "&'S has an ori$inal reference C'& of 1=5.7. &f the current C'& is %56.=, what is the current interest pay ent and par value of the "&'S? par value F %56.=?1=5.7 D <1,555 F <1,137.:1 interest pay ent F C D /.1%7E D <1,137.:1 F <1:.65

LG/

6+6 Bond Quotes Consider the followin$ three bond 4uotesJ a "reasury note 4uoted at 6:B%:, and a corporate bond 4uoted at 15/.%7, and a unicipal bond 4uoted at 151.65. &f the "reasury and corporate bonds have a par value of <1,555 and the unicipal bond has a par value of <7,555, what is the price of these three bonds in dollars? "reasury note at 6:B%:B 16:H%:?/%2E D <1,555 F <6:=.33 Corporate bond at 15/.%3B 15/.%3E D <1,555 F <1,5/%.35 !unicipal bond at 151.65B 151.65E D <7,555 F <7,567.55

LG/

6+15 Bond Quotes Consider the followin$ three bond 4uotesJ a "reasury bond 4uoted at 156B13, and a corporate bond 4uoted at 66.77, and a unicipal bond 4uoted at 155.67. &f the "reasury and corporate bonds have a par value of <1,555 and the unicipal bond has a par value of <7,555, what is the price of these three bonds in dollars? "reasury note at 156B13B 1156H13?/%2E D <1,555 F <1,563./:7 Corporate bond at 66.77B 66.77E D <1,555 F <667.75 !unicipal bond at 155.67B 155.67E D <7,555 F <7,53:.75

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Chapter 6, Solutions

Cornett, Adair, and Nofsinger

LG3

6+11 ero Cou!on Bond Pri"e Calculate the price of a 9ero coupon bond that %5 years if the ar)et interest rate is 6.7 percent. use se i+annual co poundin$B PV = FVN <1,555 <1,555 = = = <%:=.%/ N 35 /.763 (1 + i ) 1.5/%7

atures in

LG3

6+1% ero Cou!on Bond Pri"e Calculate the price of a 9ero coupon bond that 17 years if the ar)et interest rate is :.%7 percent. B use se i+annual co poundin$B PV = FVN <1,555 <1,555 = = = </3/.61 N /5 %.615 (1 + i ) 1.5/6%7

atures in

LG6

6+1/ Current #ield What.s the current yield of a 7.7 percent coupon corporate bond 4uoted at a price of 15%.5=? 7.7E K 15%.5=E F 5.57/== F 7./6E

LG6

6+13 Current #ield What.s the current yield of a :.% percent coupon corporate bond 4uoted at a price of 66.:=? :.%E K 66.:=E F 5.5:335 F :.33E

LG6

6+17 Ta$able E%ui&alent #ield What.s the ta#able e4uivalent yield on a unicipal bond with a yield to aturity of /.7 percent for an investor in the %= percent ar$inal ta# brac)et? Lse e4uation 6.3B 04uivalent ta#able yield = 1 tax rate = 1 5.%= = 3.=6E
Muni yield /.7E

LG6

6+16 Ta$able E%ui&alent #ield What.s the ta#able e4uivalent yield on a unicipal bond with a yield to aturity of %.6 percent for an investor in the // percent ar$inal ta# brac)et? Lse e4uation 6.3B 04uivalent ta#able yield = 1 tax rate = 1 5.// = 3.//E
Muni yield %.6E

LG:

6+1: Credit Ris' and #ield Man) order fro hi$hest credit ris) to lowest ris) the followin$ bonds, with the sa e ti e to aturity, by their yield to aturityB "reasury bond with yield of 7.77 percent, &(! bond with yield of :.36 percent, "ru p Casino bond with yield of =.:6 percent, and (anc *ne bond with a yield of 7.66 percent. "ru p Casino bond with yield of =.:6 percent &(! bond with yield of :.36 percent

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Chapter 6, Solutions

Cornett, Adair, and Nofsinger

(anc *ne bond with a yield of 7.66 percent "reasury bond with yield of 7.77 percent LG: 6+1= Credit Ris' and #ield Man) the followin$ bonds in order fro lowest credit ris) to hi$hest ris) all with the sa e ti e to aturity, by their yield to aturityB "reasury bond with yield of 3.67 percent, Lnited Airline bond with yield of 6.5: percent, (an) of A erica bond with a yield of 6.%7 percent, and ,ewlett 'ac)ard bond with yield of 6.:= percent. "reasury bond with yield of 3.67 percent (an) of A erica bond with a yield of 6.%7 percent ,ewlett 'ac)ard bond with yield of 6.:= percent Lnited Airline bond with yield of 6.5: percent &nter ediate 'roble s 6+16 TIPS Ca!ital Return Consider a /.7E "&'S with an issue C'& reference of 1=7.6. At the be$innin$ of this LG% year, the C'& was 166.% and was at %51./ at the end of the year. What was the capital $ain of the "&'S in dollars and in percenta$e ter s? $ain F end of year value N be$innin$ of year value F %51./?1=7.6 D <1,555 O 166.%?1=7.6 D <1,555 F <1,5=3.76 O <1,57:.11 F <%:.3= As a percenta$e, the $ain was F <%:.3= K <1,57:.11 F %.65E LG% 6+%5 TIPS Ca!ital Return Consider a %.%7E "&'S with an issue C'& reference of 1=/.7. At the be$innin$ of this year, the C'& was 16:.1 and was at %5/.= at the end of the year. What was the capital $ain of the "&'S in dollars and in percenta$e ter s? $ain F end of year value N be$innin$ of year value F %5/.=?1=/.7 D <1,555 O 16:.1?1=/.7 D <1,555 F <1,115.6/ O <1,5:3.11 F </6.7% As a percenta$e, the $ain was F </6.7% K <1,5:3.11 F /.35E LG3 6+%1 Com!ute Bond Pri"e Co pute the price of a 3.7 percent coupon bond with 17 years left to aturity and a ar)et interest rate of 6.= percent. 1Assu e interest pay ents are se i+annual.2 &s this a discount or pre iu bond?
1 1 /5 ( 1 +5.5/3 ) (ond 'rice =<%%.75 5.5/3 1,555 + =<316.57 +</66.:6 =<:=7.=1 /5 (1 +5.5/3 )

*r GF/5, &F/.3, '!"F%%.7, ;PF1555 C'" 'P F +:=7.=1 Since this is less then <1,555, it is a discount bond.

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Chapter 6, Solutions

Cornett, Adair, and Nofsinger

LG3

6+%% Com!ute Bond Pri"e Co pute the price of a 7.6 percent coupon bond with 15 years left to aturity and a ar)et interest rate of :.5 percent. 1Assu e interest pay ents are se i+annual.2 &s this a discount or pre iu bond?
1 1 (1 +5.5/7) %5 (ond 'rice =<%=.55 5.5/7 1,555 + =</6:.67 +<75%.76 =<655.71 %5 (1 +5.5/7)

*r GF%5, &F/.7, '!"F%=, ;PF1555 C'" 'P F +655.71 Since this is less then <1,555, it is a discount bond. LG3 6+%/ Com!ute Bond Pri"e Calculate the price of a 6.% percent coupon bond with 1= years left to aturity and a ar)et interest rate of 7.6 percent. 1Assu e interest pay ents are se i+annual.2 &s this a discount or pre iu bond?
1 1 (1 +5.5%67)/6 (ond 'rice =</1.55 5.5%67 1,555 + =<6=1.== +</71.11 =<1,5/%.66 /6 (1 +5.5%67)

*r GF/6, &F%.67, '!"F/1, ;PF1555 C'" 'P F +1,5/%.66 Since the bond is $reater then <1,555, it is a pre iu bond. LG3 6+%3 Com!ute Bond Pri"e Calculate the price of a 7.: percent coupon bond with %7 years left to aturity and a ar)et interest rate of 3.= percent. 1Assu e interest pay ents are se i+annual.2 &s this a discount or pre iu bond?
1 1 (1 +5.5%3 ) 75 (ond 'rice =<%=.75 5.5%3 1,555 + =<=%3.:/ +</57.36 =<1,1/5.%% (1 +5.5%3 ) 75

*r GF75, &F%.3, '!"F%=.75, ;PF1555 C'" 'P F +1,1/5.%% Since the bond is $reater then <1,555, it is a pre iu bond. LG7 6+%7 Bond Pri"es and Interest Rate C(anges A 7.:7 percent coupon bond with 15 years left to aturity is priced to offer a 6.7 percent yield to aturity. >ou believe that in one year, the yield to aturity will be 6.5 percent. What is the chan$e in price the bond will e#perience in dollars? Co pute the current bond priceB
1 1 (1 +5.5/%7) %5 (ond 'rice =<%=.:7 5.5/%7 1,555 + =<31=.51 +<7%:.3: =<637.3= %5 (1 +5.5/%7)

*r GF%5, &F/.%7, '!"F%=.:7, ;PF1555 C'" 'P F +637.3=

:+=

Chapter 6, Solutions

Cornett, Adair, and Nofsinger

Gow co pute the price in one yearB

1 1 1= ( 1 +5.5/) (ond 'rice =<%=.:7 5.5/ 1,555 + =</67.31 +<7=:.35 =<6=%.=1 1= ( 1 + 5.5/)

*r GF1=, &F/.5, '!"F%=.:7, ;PF1555 C'" 'P F +6=%.=1 So the dollar chan$e in price isB <6=%.=1 O <637.3= F </:.// LG7 6+%6 Bond Pri"es and Interest Rate C(anges A 6.7 percent coupon bond with 13 years left to aturity is priced to offer a :.% percent yield to aturity. >ou believe that in one year, the yield to aturity will be 6.= percent. What is the chan$e in price the bond will e#perience in dollars? Co pute the current bond priceB
1 1 %= ( 1 +5.5/6 ) (ond 'rice =</%.75 5.5/6 1,555 + =<76:.3% +</:1.3: =<6/=.=6 %= (1 +5.5/6 )

*r GF%=, &F/.6, '!"F/%.75, ;PF1555 C'" 'P F +6/=.=6 Gow co pute the price in one yearB
1 1 %6 ( 1 +5.5/3 ) (ond 'rice =</%.75 5.5/3 1,555 + =<777.13 +<316.%3 =<6:3./= %6 (1 +5.5/3 )

*r GF%6, &F/.3, '!"F/%.75, ;PF1555 C'" 'P F +6:3./= So the dollar chan$e in price isB <6:3./= O <6/=.=6 F </7.36 LG6 6+%: #ield to Maturity A 6.=7 percent coupon bond with %6 years left to aturity is offered for sale at <1,5/7.%7. What yield to aturity is the bond offerin$? 1Assu e interest pay ents are paid se i+annually.2 GF7%, 'PF+15/7.%7, '!"F/3.%7, ;PF1555 6.7:E LG6 C'" & F /.%63E, >"! F /.%63E D % F

6+%= #ield to Maturity A 7.%7 percent coupon bond with 13 years left to aturity is offered for sale at <677.:7. What yield to aturity is the bond offerin$? 1Assu e interest pay ents are paid se i+annually.2 GF%=, 'PF+677.:7, '!"F%6.%7, ;PF1555 7.:1E C'" & F %.=7:E, >"! F %.=7:E D % F

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Chapter 6, Solutions

Cornett, Adair, and Nofsinger

LG6

6+%6 #ield to Call A 6.:7 percent coupon bond with %6 years left to aturity can be called in 6 years. "he call pre iu is one year of coupon pay ents. &t is offered for sale at <1,1/7.%7. What yield to call of the bond? 1Assu e that interest pay ents are paid se i+annually.2 GF1%, 'PF+11/7.%7, '!"F//.:7, ;PF156:.75 C'" & F %.731E, >"C F %.731E D % F 7.5=E

LG6

6+/5 #ield to Call A 7.%7 percent coupon bond with 13 years left to aturity can be called in 3 years. "he call pre iu is one year of coupon pay ents. &t is offered for sale at <1,5:7.75. What yield to call of the bond? 1Assu e that interest pay ents are paid se i+annually.2 GF=, 'PF+15:7.75, '!"F%6.%7, ;PF157%.75 C'" & F %.16/E, >"C F %.16/E D % F 3./6E

LG6

6+/1 Com!aring Bond #ields A client in the // percent ar$inal ta# brac)et is co parin$ a unicipal bond that offers a 3.7 percent yield to aturity and a si ilar+ris) corporate bond that offers a 6.37 percent yield. Which bond will $ive the client ore profit after ta#es? ;irst deter ine the 0">B 04uivalent ta#able yield = 1 tax rate = 1 5.// = 6.:%E Since 6.:%E Q 6.37E, the client should ta)e the unicipal bond.
Muni yield 3.7E

LG6

6+/% Com!aring Bond #ields A client in the %= percent ar$inal ta# brac)et is co parin$ a unicipal bond that offers a 3.7 percent yield to aturity and a si ilar+ris) corporate bond that offers a 6.37 percent yield. Which bond will $ive the client ore profit after ta#es? ;irst deter ine the 0">B 04uivalent ta#able yield = 1 tax rate = 1 5.%= = 6.%7E Since 6.%7E R 6.37E, the client should ta)e the corporate bond.
Muni yield 3.7E

Advanced 'roble s 6+// TIPS Total Return Meconsider the /.7E "&'S discussed in proble 6+16. &t was LG% issued with C'& reference of 1=7.6. "he bond is purchased at the be$innin$ of the year 1after the interest pay ent2, when the C'& was 166.%. ;or the interest pay ent in the iddle of the year, the C'& was 166.6. Gow, at the end of the year, the C'& is %51./ and the interest pay ent has been ade. What is the total return of the "&'S in dollars and in percenta$e ter s for the year? capital $ain F end of year value N be$innin$ of year value F

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Chapter 6, Solutions

Cornett, Adair, and Nofsinger

%51./?1=7.6 D <1,555 O 166.%?1=7.6 D <1,555 F <1,5=3.76 O <1,57:.11 F <%:.3= "he id+year interest pay ent wasB C D /.7E D 166.6?1=7.6 D <1,555 F <1=.=% "he end+of+year interest pay ent wasB C D /.7E D %51./?1=7.6 D <1,555 F <1=.6= "otal dollar return F <%:.3= H <1=.=% H <1=.6= F <67.%= As a percenta$e, the return was F <67.%= K <1,57:.11 F 6.1=E LG% 6+/3 TIPS Total Return Meconsider the %.%7E "&'S discussed in proble 6+%5. &t was issued with C'& reference of 1=/.7. "he bond is purchased at the be$innin$ of the year 1after the interest pay ent2, when the C'& was 16:.1. ;or the interest pay ent in the iddle of the year, the C'& was %55.1. Gow, at the end of the year, the C'& is %5/.= and the interest pay ent has been ade. What is the total return of the "&'S in dollars and in percenta$e ter s for the year? $ain F end of year value N be$innin$ of year value F %5/.=?1=/.7 D <1,555 O 16:.1?1=/.7 D <1,555 F <1,115.6/ O <1,5:3.11 F </6.7% "he id+year interest pay ent wasB C D %.%7E D %55.1?1=/.7 D <1,555 F <1%.%: "he end+of+year interest pay ent wasB C D %.%7E D %5/.=?1=/.7 D <1,555 F <1%.36 "otal dollar return F </6.7% H <1%.%: H <1%.36 F <61.%= As a percenta$e, the return was F <61.%= K <1,5:3.11 F 7.:1E LG7 6+/7 Bond Pri"es and Interest Rate C(anges A 6.%7 percent coupon bond with %% years left to aturity is priced to offer a 7.7 percent yield to aturity. >ou believe that in one year, the yield to aturity will be 6.5 percent. &f this occurs, what would be the total return of the bond in dollars and percent? Co pute the current bond priceB
1 1 33 ( 1 +5.5%:7) (ond 'rice =</1.%7 5.5%:7 1,555 + =<:61.6% +</5/.11 =<1,567.5/ 33 (1 +5.5%:7)

*r GF33, &F%.:7, '!"F/1.%7, ;PF1555 C'" 'P F +1567.5/ Gow co pute the price in one yearB
1 1 (1 +5.5/) 3% (ond 'rice =</1.17 5.5/ 1,555 + =<:35.6: +<%==.66 =<1,5%6.6/ 3% (1 +5.5/)

*r GF3%, &F/.5, '!"F/1.%7, ;PF1555 C'" 'P F +15%6.6/ So the dollar chan$e in price H interest pay ents areB <1,5%6.6/ O <1,567.5/ H <6%.75 F <+%.65 "he percenta$e return isB +%.65 K 1,567.5/ F +5.%6E LG7 6+/6 Bond Pri"es and Interest Rate C(anges A :.7 percent coupon bond with 1/ years left to aturity is priced to offer a 6.%7 percent yield to aturity. >ou believe that in one

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Cornett, Adair, and Nofsinger

year, the yield to aturity will be :.5 percent. &f this occurs, what would be the total return of the bond in dollars and percenta$e ter s? Co pute the current bond priceB
1 1 (1 +5.5/1%7) %6 (ond 'rice =</:.75 5.5/1%7 1,555 + =<665.=3 +<336./5 =<1,115.13 %6 (1 +5.5/1%7)

*r GF%6, &F/.1%7, '!"F/:.75, ;PF1555 C'" 'P F +1115.13 Gow co pute the price in one yearB
1 1 %3 ( 1 +5.5/7) (ond 'rice =</:.75 5.5/7 1,555 + =<65%.16 +<3/:.66 =<1,535.17 %3 ( 1 +5.5/7)

*r GF%3, &F/.7, '!"F/:.75, ;PF1555 C'" 'P F +1535.17 So the dollar chan$e in price H interest pay ents areB <1,535.17 O <1,115.13 H <:7.55 F <7.51 "he percenta$e return isB 7.51 K 1,115.13 F 5.37E LG6 6+/: #ields o) a Bond A /.:7 percent coupon unicipal bond has 13 years left to aturity and has a price 4uote of 6=.37. "he bond can be called in 3 years. "he call pre iu is one year of coupon pay ents. Co pute and discuss the bond.s current yield, yield to aturity, ta#able e4uivalent yield 1for an investor in the /7 percent ar$inal ta# brac)et2, and yield to call. 1Assu e interest pay ents are paid se i+annually and a par value of <7,555.2 Current yield F /.:7 K 6=.37 F /.=1E >"!B GF%=, 'PF+36%%.75, '!"F6/.:7, ;PF7555 C'" & F 1.63:E, >"! F 1.63:E D % F /.=6E
04uivalent ta#able yield = Muni yield /.=6E = = 7.6=E 1 tax rate 1 5./7

>"CB GF=, 'PF+36%%.75, '!"F6/.:7, ;PF71=:.75 C'" & F %.7%E, >"! F %.7%E D % F 7.53E "he current yield is hi$her than the coupon rate because this is currently a discount bond. "his is also shown in a >"! that is $reater than the coupon rate. "he >"C is co paratively hi$h, but it is currently not li)ely that the bond will be called early since interest rates are hi$h. LG6 6+/= #ields o) a Bond A 3.%7 percent coupon unicipal bond has 1= years left to aturity and has a price 4uote of 6:.67. "he bond can be called in = years. "he call pre iu is one year of coupon pay ents. Co pute and discuss the bond.s current yield, yield to aturity, ta#able e4uivalent yield 1for an investor in the /7 percent ar$inal ta#

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Cornett, Adair, and Nofsinger

brac)et2, and yield to call. 1Assu e interest pay ents are paid se i+annually and a par value of <7,555.2 Current yield F 3.%7 K 6:.67 F 3./7E >"!B GF/6, 'PF+3==%.75, '!"F156.%7, ;PF7555 C'" & F %.%%E, >"! F %.%%E D % F 3.33E
04uivalent ta#able yield = Muni yield 3.33E = = 6.=/E 1 tax rate 1 5./7

>"CB GF16, 'PF+3==%.75, '!"F156.%7, ;PF7%1%.75 C'" & F %.7%E, >"! F %.7%E D % F 7.53E "he current yield is hi$her than the coupon rate because this is currently a discount bond. "his is also shown in a >"! that is $reater than the coupon rate. "he >"C is co paratively hi$h, but it is currently not li)ely that the bond will be called early since interest rates are hi$h. LG: 6+/6 Bond Ratings and Pri"es A corporate bond with a 6.7 percent coupon has 17 years left to aturity. &t has had a credit ratin$ of ((( and a yield to aturity of :.% percent. "he fir has recently $otten into so e trouble and the ratin$ a$ency is down$radin$ the bonds to ((. "he new appropriate discount rate will be =.7 percent. What will be the chan$e in the bond.s price in dollars and percenta$e ter s? 1Assu e interest pay ents are paid se i+annually.2 Co pute the current bond priceB
1 1 /5 ( 1 +5.5/6 ) (ond 'rice =</%.75 5.5/6 1,555 + =<765./% +</36.11 =<6/6.3/ /5 (1 +5.5/6 )

*r GF/5, &F/.6, '!"F/%.75, ;PF1555 C'" 'P F +6/6.3/ Gow co pute the price after the ratin$ chan$eB
1 1 (1 +5.53%7)/5 (ond 'rice =</%.75 5.53%7 1,555 + =<737./% +<%=6.=6 =<=/%.%1 /5 (1 +5.53%7)

*r GF/5, &F3.%7, '!"F/%.75, ;PF1555 C'" 'P F +=/%.%1 So the dollar chan$e in price isB <=/%.%1 O <6/6.3/ F <+153.%% "he percenta$e return isB +153.%% K 6/6.3/ F +11.1/E LG: 6+35 Bond Ratings and Pri"es A corporate bond with a 6.:7 percent coupon has 15 years left to aturity. &t has had a credit ratin$ of (( and a yield to aturity of =.% percent. "he fir has recently beco e ore financial stable and the ratin$ a$ency is up$radin$ the bonds to (((. "he new appropriate discount rate will be :.1 percent. What

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Chapter 6, Solutions

Cornett, Adair, and Nofsinger

will be the chan$e in the bond.s price in dollars and percenta$e ter s? 1Assu e interest pay ents are paid se i+annually.2 Co pute the current bond priceB
1 1 (1 +5.531) %5 (ond 'rice =<//.:7 5.531 1,555 + =<373.63 +<33:.:5 =<65%./3 %5 (1 +5.531)

*r GF%5, &F3.1, '!"F//.:7, ;PF1555 C'" 'P F +65%./3 Gow co pute the price after the ratin$ chan$eB
1 1 %5 ( 1 +5.5/77) (ond 'rice =<//.:7 5.5/77 1,555 + =<3::.71 +<36:.:/ =<6:7.%3 %5 (1 +5.5/77)

*r GF%5, &F/.77 '!"F//.:7, ;PF1555 C'" 'P F +6:7.%3 So the dollar chan$e in price isB <6:7.%3 O <65%./3 F <:%.65 "he percenta$e return isB :%.65 K 65%./3 F =.5=E 6+31 E$"el Problem Say that in Sune of %55=, a co pany issued bonds that are scheduled to ature in Sune of %511. "he coupon rate is 7.:7E and is paid se i+annually. "he bond issue was rated AAA. A. (uild a spreadsheet that shows how uch oney the fir pays for each interest rate pay ent and when those pay ents will occur if the bond issue sells 75,555 bonds. (. &f the bond issue ratin$ would have been (((, then the coupon rate would have been 6./5E. Show the interest pay ents with this ratin$. 0#plain why bond ratin$s are i portant to fir s issuin$ capital debt. C. Consider that interest rates in the econo y increased in the first half of %55=. &f the fir would have issued the bonds in Sanuary of %55=, then the interest rates would have only been 7.35E. ,ow uch e#tra oney per year is the fir payin$ because it issued the bonds in Sune instead of Sanuary? "he spreadsheet
Coupon MateF 'ar Palue F Gu ber of (onds F

i$ht loo) li)eB

A* 7.:7E <1,555 75,555 &nterest pay ents 5 <1,3/:,755 <1,3/:,755 <1,3/:,755 B* 6./5E <1,555 75,555 &nterest pay ents 5 <1,7:7,555 <1,7:7,555 <1,7:7,555 C* 7.35E <1,555 75,555 &nterest pay ents 5 <5 <1,/75,555 <1,/75,555

Sun+5= 8ec+5= Sun+56 8ec+56

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Chapter 6, Solutions

Cornett, Adair, and Nofsinger

Sun+15 8ec+15 Sun+11 8ec+11 Sun+1%

<1,3/:,755 <1,3/:,755 <1,3/:,755 <1,3/:,755

<1,7:7,555 <1,7:7,555 <1,7:7,555 <1,7:7,555

<1,/75,555 <1,/75,555 <1,/75,555 <1,/75,555 <1,/75,555

(. "he better the bond ratin$, the lower the interest rate a fir will have to pay. &n this e#a ple, the fir has to pay <%:7,555 ore each year in interest pay ent with the lower bond ratin$. C. "he fir is payin$ <1:7,555 per year the rates declined. Resear"( It+ Bond In)ormation ,nline &nfor ation on the bond ar)et is widely available in papers li)e The Wall Street Journal and Barrons. (ond infor ation can also be found online at financial websites li)e finance.yahoo.co , the (ond !ar)et Association 1www.bond ar)ets.co 2, nasdbondinflo.co . "he bond credit ratin$ a$encies also aintain websites with their own bond ar)et news. >ou can follow the bond ar)et easily at places li)e the >ahooT ;inance website. Clic) on the (ond lin) in the enu to $o to their (ond Center. (ond yields for various aturity "reasury securities are shown for today and for previous days. "he (ond Co posite Mates lin) shows si ilar co parisons for unicipal and corporate bonds too. (ond calculators are also available for free on the Web. Co pare a bond price result fro your calculator or the price e4uation with the online bond calculator result at &nvestopedia at www.investopedia.co ?calculator?(ond'rice.asp# S*LL"&*GB All answers will be different. ,ere is an e#a ple answerB An e#a ple done on the websiteU ore in interest because it issued its bonds before

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Chapter 6, Solutions

Cornett, Adair, and Nofsinger

1 1 (1 +5.5% )6 (ond 'rice =<1:.75 5.5%

1,555 + =<6=.5/ +<==:.6: =<6=6.55 6 (1 +5.5% )

*r GF6, &F%, '!"F1:.75, ;PF1555 C'" 'P F +6=7.666 All co putations are the sa e. Integrated Mini Case- Cor!orate Bond Credit Ris' C(anges and Bond Pri"es Land.o."oys is a profitable, ediu si9ed, retail co pany. Several years a$o it issued a 6C percent coupon bond, which pays interest se i+annually. "he bond will ature in ten years and is currently priced in the ar)et as <1,5/:.16. "he avera$e yields to aturity for 15+year corporate bonds are reported in the followin$ table by bond ratin$.
Bond Rating AAA AA A ((( #ield ./0 7.3 7.: 6.5 6.7 Bond Rating (( ( CCC CC C 8 #ield ./0 :./ =.% 6.% 15.7 1%.5 13.7

'eriodically, one co pany will purchase another by buyin$ all of the tar$et fir .s stoc). "he bonds of the tar$et fir continue to e#ist. "he debt obli$ation is assu ed by the new fir . "he credit ris) of the bonds often chan$es because of this type of an event.

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Chapter 6, Solutions

Cornett, Adair, and Nofsinger

Suppose that the fir "reasure "oys a)es an announce ent that they are purchasin$ Land.o."oys. 8ue to "reasury "oy.s pro-ected financial structure after the purchase, Standard V 'oors states that the bond ratin$ Land.o."oys bonds will chan$e to ((. A. Co pute the yield to aturity of Land.o."oys bonds before the purchase announce ent and us it to deter ine the li)ely bond ratin$. (. Assu e the bond.s price chan$es to reflect the new credit ratin$. What is the new price? 8id the price increase or decrease? C. What is the dollar chan$e and percenta$e chan$e in the bond price? 8. ,ow do the bond investors feel about the announce ent? S*LL"&*GB A. >"!B GF%5, 'PF+1,5/:.16, '!"F/%.75, ;PF1555 C'" & F /.55E, >"! F /.55E D % F 6.55E "his bond is li)ely rated as an @AA. (. "he new >"! will li)ely be :./E annually, so the price will chan$e toB GF%5, &F/.67, '!"F/%.75, ;PF1555 C'" 'P F +63/.61 "he price decreased because it $ot ris)ier. C. "he price chan$e would be <63/.61 O <1,5/:.16 F +<6/.%= "he chan$e as a percenta$e would be +<6/.%= K <1,5/:.16 F +=.66E 8. &n a fir buyout, the stoc) holders of the tar$et fir earn a nice profit. ,owever, the bondholders of the tar$et fir can be unhappy if the new co bined fir has a worse bond ratin$, li)e in this case.

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