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Chapter 12 - Principles of Bond Valuation and Investment

SOLUTIONS MANUAL
CHAPTER 12
PRINCIPLES OF BOND VALUATION AND INVESTMENT
Answers to Text Discussion Questions
1. Why are bonds not necessarily a conservative investment?
12-1. Since bond prices are sensitive to interest rate changes, capital gains or losses are
possible even though interest is paid regularly.
2. How can the market price of a bond be described in terms of present value?
12-2. The price of a bond is the present value of the annuity created by the interest
payments plus the present value of the lump sum of principal returned at maturity.
3. Why does a bond price change when interest rates change?
12-3. Since the bond has a fixed return (the interest promised) based on the bond
contract, the market price of a bond changes to reflect changes in market interest
rates. A bond's price changes to indicate the present value of future cash return,
both interest and principal based on market interest rates (discount factors).
Floating rate bonds are an exception to this principle.
4. Why is current yield not a good indicator of bond returns? (Relate your answer to
maturity considerations.)
12-4. The current yield does not consider the length of time to maturity. A dollar
received this year is worth more than dollars received in future years.
5. Describe how yield to maturity is the same concept as the internal rate of return (or
true yield) on an investment.
12-5. Yield to maturity is the same concept as internal rate of return or true yield
because it is the interest rate (i) at which you can discount the future coupon
payments (Ct) and maturity value (Pn) to arrive at a known current value (V) of
the bond.
6. What is the significance of the yield-to-call calculation?
12-6. If a bond is callable, the yield to call calculation shows what the yield for that
time period would be as compared to yield to maturity (which you may never get
to) or some other length of time.

12-1

Chapter 12 - Principles of Bond Valuation and Investment


7. What is the bond reinvestment assumption? Is this necessarily
correct?

12-7. It is assumed that funds are reinvested at the yield from the investment. This is not
necessarily the case. Reinvestment may take place at a higher or lower rate (as
will be discussed in the next chapter).
8. What is the meaning of term structure of interest rates?
12-8. The term structure of interest rates depicts the relationship between maturity and
interest rates. It is sometimes called a yield curve because yields on existing
securities, having maturities anywhere from three months to 30 years, are plotted
on a graph to develop the curve.
9. What does an ascending term structure pattern tend to indicate?
12-9. When the term structure is in an ascending posture (short-term rates are lower
than long-term rates), it is a general signal that interest rates will rise in the future.
10. Explain the general meaning of the expectations hypothesis as it relates to the term
structure of interest rates.
12-10. The hypothesis is that any long-term rate is an average of the expectation of future
short-term rates over the applicable time horizon. Thus, if lenders expect shortterm rates to be continually increasing in the future, they will demand higher
long-term rates. Conversely, if they anticipate short-term rates to be declining,
they will accept lower long-term rates.
11. Explain the liquidity preference theory as it relates to the term structure of interest
rates.
12-11. The shape of the term structure of interest rates tends to be upward sloping more
than any other pattern. This reflects recognition of the fact that long-term maturity
obligations are subject to greater price change movements when interest rates
change. Because of the increased risk of holding longer-term maturities, investors
demand a higher return to hold long-term securities relative to short-term
securities. This is called the liquidity preference theory of interest rates. Since
short-term securities are more easily turned into cash without the risk of large
price changes, investors will pay a higher price and receive a lower yield.

12-2

Chapter 12 - Principles of Bond Valuation and Investment


12. How might the market segmentation theory help to explain why shortterm rates on government securities increase when bank loan demand
becomes high?

12-12. When bank loan demand becomes high, banks are likely to partially withdraw
from investments in government securities. Since banks are an important part of
the short-term side of the market, their reduced demand will likely drive up shortterm rates on government securities.
13. Under what circumstances would the yield spread on different classes of debt
obligations tend to be largest?
12-13. The yield spread represents the difference in returns for different classes of bonds
based on ratings. The yield spread tends to be largest when there is a low degree of
confidence in the economy as in the early phases of a recession as investors attempt to
shift out of low grade securities into strong instruments.
14. List the six principles associated with bond-pricing relationships.
12-14. 1.
2.
3.
4.
5.
6.

Bond prices and interest rates are inversely related.


Prices of long-term bonds are more sensitive to a change in yields to
maturity than short-term bonds.
Bond price sensitivity increases at a decreasing rate as maturity increases.
Bond prices are more sensitive to a decline in market yield to maturity
than to a rise in market yield to maturity.
Prices of low coupon bonds are more sensitive to a change in yields to
maturity than high coupon bonds.
Bond prices are more sensitive when yields to maturity are low than when
yields to maturity are high.

15. How do margin requirements affect investor strategy for bonds?


12-15. Borrowing to purchase bonds requires relatively little margin. For government
securities, the amount be put down may be as little as 5 percent and for corporate
bonds, it may be 30 percent. The leverage available can affect returns
dramatically. Investors may use margin to enhance percentage returns if they
expect interest rates to go down, but margin can also cause large percentage losses
if they are wrong and interest rates go up.

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Chapter 12 - Principles of Bond Valuation and Investment


16. Explain the benefits derived from investing in deep discount bonds.

12-16. Deep discount bonds have almost no change of being called away even if prices
go up because the value is already far removed from par. Secondly, deep discount
bonds offer the opportunity for higher price increases than high coupon bonds if
interest rates decline.
17. What is a bond swap investment strategy? Explain how it might relate to tax
planning.
12-17. The term "Swap" refers to the procedure of selling out of a given bond position
and immediately buying into another one with similar attributes in an attempt to
improve overall portfolio return or performance.
For tax planning purposes, you might sell a bond on which you have a large loss
and take a reduction against other income. You then take the proceeds from the
sale and reinvest in a bond of equal risk, and you will have increased your total
cash returns because of tax benefits.
PROBLEMS
Bond price
1. Given a 10-year bond that sold for $1,000 with a 13 percent coupon rate, what would
be the price of the bond if interest rates in the marketplace on similar bonds are now 10
percent? Interest is paid semiannually. Assume a 10-year time period.
12-1. PV of $65 semiannually for n = 20 and i = 5%
(Table 12-1 or Appendix D)

$65 12.462 = $810.03

PV of $1,000 semiannually for n = 20 and i = 5%


$1, 000 .377

(Table 12-2 or Appendix C)

12-4

377.00
$1,187.03

Chapter 12 - Principles of Bond Valuation and Investment

Bond price
2. Given a 15-year bond that sold for $1,000 with a 9 percent coupon rate, what would be
the price of the bond if interest rates in the marketplace on similar bonds are now 12
percent? Interest is paid semiannually. Assume a 15-year time period.
12-2. PV of $45 semiannually for n = 30 and i = 6%
(Table 12-1 or Appendix D)

$45 13.765 = $619.43

PV of $1,000 semiannually for n = 30 and i = 6%


$1, 000 .174

(Table 12-2 or Appendix C)

174.00
$793.43

Bond price
3. Given the facts in problem 2, what would be the price if interest rates go down to 8
percent? (Once again, do a semiannual analysis.)
12-3. PV of $45 semiannually for n = 30 and i = 4%
(Table 12-1 or Appendix D)

$45 17.292 = $778.14

PV of $1,000 semiannually for n = 30 and i = 4%


$1, 000 .308

(Table 12-2 or Appendix C)

308.00
$1, 086.14

Use of bond table


4. Using Table 123, on page 317 determine the price of a
a. 10 percent coupon rate bond, with 20 years to maturity and a 14 percent yield to
maturity.
b. 12 percent coupon rate bond with 10 years to maturity and an 8 percent yield to
maturity.
12-4. a)

73.34% $1,000 = $ 733.40

b) 127.18% $1,000 = $1,271.80

12-5

Chapter 12 - Principles of Bond Valuation and Investment

Use of bond table


5. Using Table 123, on page 317
Assume you bought a bond with a 10 percent coupon rate with 20 years to maturity at a
yield to maturity of 14 percent. Further assume 10 years later the yield to maturity is 8
percent.
Determine the price of the bond that you initially paid and the bond price with 10
years remaining to maturity. Also, compute the dollar and percentage profit related to the
bond over the 10-year holding period.
12-5. 20 years, 14 percent 73.34% $1,000 = $ 733.40
10 years, 8 percent 113.50% $1,000 = $1,135.00
Dollar Profit
$1,135.00
733.40

Value with10 years remaining


Purchase price

$ 401.60

Dollar profit

Percent Profit
Dollar profit $401.60

54.76%
Purchase price $733.40
Current yield
6. What is the current yield of an 8 percent coupon rate bond priced at $877.60?
12.6.

$80 / $877.60 = 9.12%

Yield to maturity
7. What is the yield to maturity for the data in problem 6? Assume there are 10 years left
to maturity. It is a $1,000 par value bond. Use the trial-and-error approach with annual
analysis. [Hint: Because the bond is trading for less than par value, you can assume the
interest rate (i) for which you are solving is greater than the coupon rate of 8 percent.]
12.7.

Since the interest rate must be greater than 8%, we will try 9% as a first
approximation.
PV of $80 annually for n = 10, i = 9%
(Table 12-1 or Appendix D)

$80 6.418 = $513.44

PV of $1,000 annually for n = 10, i = 9%

12-6

Chapter 12 - Principles of Bond Valuation and Investment

$1, 000 .422

(Table 12-2 or Appendix D)

12-7

422.00
$935.44

Chapter 12 - Principles of Bond Valuation and Investment

At a 9% discount rate, the answer is $935.44. This is higher than our desired value of
$877.60. In order to bring the value down, we will use a higher interest rate. Lets try
10%.
PV of $80 annually for n = 10, i = 10%
(Table 12-1 or Appendix D)

$80 6.145 = $491.60

PV of $1,000 annually for n = 10, i = 10%


$1, 000 .386

(Table 12-2 or Appendix C)

386.00
$877.60

A 10% discount rate provides the bond price of $877.60. Ten percent is the
yield to maturity.
Yield to maturity
8. What is the yield to maturity for a 10 percent coupon rate bond priced at $1,090.90?
Assume there are 20 years left to maturity. It is a $1,000 par value bond. Use the trialand-error approach with annual analysis. (Hint: Because the bond is trading at a price
above par value, first decide whether your initial calculation should be at an interest rate
above or below the coupon rate.)
12-8. With the bond trading above par value, the discount rate must be below the
coupon rate of 10%. Lets try 9%.
PV of $100 annually for n = 20, i = 9%
(Table 12-1 or Appendix D)

$100 9.129 = $912.90

PV of $1,000 annually for n = 20, i = 9%


$1, 000 .178

(Table 12-2 or Appendix C)

178.00
$1, 090.90

Since 9% provides the desired bond value of $1,090.90, it is the yield to maturity.
Comparison of yields
9. What is the current yield in problem 8? Why is it slightly higher than the yield to
maturity?
12-9. $100/$1,090.90 = 9.17%
It is higher than yield to maturity because it does not take into consideration the
fact that the bond price will decline from $1,090.90 to $1,000 over the next 20
years. This factor lowers the yield to maturity.
12-8

Chapter 12 - Principles of Bond Valuation and Investment

Current yield and yield to maturity comparison


10. A 15-year, 7 percent coupon rate bond is selling for $839.27.
a. What is the current yield?
b. What is the yield to maturity using the trial-and-error approach with annual
calculations?
c. Why is the current yield higher/lower than the yield to maturity?
12-10. a) Current Yield
$70
$8.34%
$839.27
b) Since the bond is trading below par value, the yield to maturity (interest rate)
must be above 7 percent. Lets try 8 percent.
PV of $80 annually for n = 15, i = 8%
(Table 12-1 or Appendix D)

$70 8.559 = $599.13

PV of $1000 for n = 15, i = 8%


$1, 000 .315

(Table 12-2 or Appendix C)

$315.00
$914.13

At an 8% discount rate, the answer is $914.13. This is higher than our desired
value of $839.27. In order to bring the value down, we must use a higher interest
rate. Lets try 9%.
PV of $80 annually for n = 15, i = 9%
(Table 12-1 or Appendix D)

$70 8.061 = $564.27

PV of $1000 for n = 15, i = 9%


$1, 000 .275

(Table 12-2 or Appendix C)

$275.00
$839.27

A 9% discount rate provides the bond price $839.27. 9% is the yield to maturity.

12-9

Chapter 12 - Principles of Bond Valuation and Investment

Approximate yield to maturity


11. What is the approximate yield to maturity of a 14 percent coupon rate, $1,000 par
value bond priced at $1,160 if it has 16 years to maturity? Use Formula 122 on page
320.

12-11.

y'

Par Value (Pn ) Market value (V)


Number of periods to Maturit y (n)
(0.6) Market Value (V) + (0.4) Par Value(Pn )

Coupon payment (C t )

The calculation is done on an annual basis.


$1, 000 $1,160
16
y'
(0.6)$1,160 + (0.4)$1, 000
$160
$140
16

$696 $400
$140 $10 $130

11.86%
$1, 096
$1, 096
$140

Yield to call
12. a. Using the facts given in problem 11, what would be the yield to call if the call can
be made in four years at a price of $1,080? Use Formula 123 on page 321.
b. Explain why the answer is lower in part a than in problem 11.
c. Given a call value of $1,080 in four years, is it likely that the bond price would actually
get to $1,160?

12-12. a)

Call Price (Pc ) Market value (V)


Number of periods to Call (n c )
(0.6) Market Value (V) + (0.4) Call Price (Pc )

Coupon payment (C t )
y'

The calculation is done on an annual basis.


$1, 080 $1,160
4
y'
(0.6)$1,160 + (0.4)$1, 080
$80
$140
4

$696 $432
$140 $20 $120

10.64%
$1,128
$1,128
$140

12-10

Chapter 12 - Principles of Bond Valuation and Investment

b) Because the bond is callable at $1,080 in four years, the investor must consider
the $80 loss in value over four years from $1,160 to $1,080 ($20 per year). This
substantially reduces yield.
In problem 11, there is also a loss in value from $1,160 to $1,000, but it takes
place over 16 years (only $10 per year). The normal amortization of the premium
over the life of the bond has less of a negative effect on yield.
c) No. The threat of the call will likely keep the price closer to $1,080 (though
with four years to call, a littler higher value than $1,080 may be possible if the
yield on the bond is well above market rates).
Anticipated realized yield
13. a. Using the facts given in problem 11, what would be the anticipated realized yield if
the forecast is that the bond can be sold in three years for $1,280? Use Formula 124 on
page 322. Continue to assume the bond has a 14 percent coupon rate ($140) and a current
price of $1,160.
b. Now break down the anticipated realized yield between current yield and capital
appreciation. (Hint: Compute current yield and subtract this from anticipated realized
yield to determine capital appreciation.)

12-13. a)

Realized Price (Pr ) Market value (V)


Number of periods to realization (n r )
(0.6) Market Value (V) + (0.4) Realized Price (Pr )

Coupon payment (C t )
y 'r

The calculation is done on an annual basis.


$1, 280 $1,160
3
y 'r
(0.6) ($1,160) + (0.4) ($1, 280)
$120
$140
3

$696 $512
$140 $40 $180

14.90%
$1, 208
$1, 208
$140

Coupon payment $140

12.07%
Price
$1,160
b)
Capital appreciation = Anticipated realized yield Current yield
14.90% 12.07% 2.83%
Current yield =

12-11

Chapter 12 - Principles of Bond Valuation and Investment

Use of bond table


14. An investor places $800,000 in 30-year bonds (12 percent coupon rate), and interest
rates decline by 3 percent. Use Table 124 on page 327 to determine the current value of
the portfolio.
$ 800, 000
30.96%
12-14.

$ 247, 680
$ 800, 000
247, 680
$1, 047, 680

Initial value
(Table12 - 4 for12%,30 years,
Gain
Initial value
Gain
Total value

Use of bond table


15. Use Table 124 on page 327 to describe the worst possible scenario for a $1,000
bond based on yield change, years to maturity, and coupon rate. What would be the price
of the bond?
12-15. The worst possible care would be for yield to rise by the maximum amount in the
table (+3%), for the longest maturity (30 years), at the lowest coupon rate (6%).
A decline of 30.82 percent would take place and the new price of the bond
would be $691.80.
$ 1, 000
69.18%
$ 691.80

Par value
(100% 30.82%)
New bond price

12-12

Chapter 12 - Principles of Bond Valuation and Investment

Expectations hypothesis
16. The following pattern for one-year Treasury bills is expected over the next four
years:
Year 1 -5%
Year 2 -7%
Year 3-10%
Year 4-11%
a. What return would be necessary to induce an investor to buy a two-year security?
b. What return would be necessary to induce an investor to buy a three-year security?
c. What return would be necessary to induce an investor to buy a four-year security?
d. Diagram the term structure of interest rates for years 1 through 4.

12-16. a) 2-year security (5% + 7%)/2 = 6%


b) 3-year security (5% + 7% + 10%)/3 = 7.33%
c) 4-year security (5% + 7% + 10% + 11%)/4 = 8.25%
d) Yield

Maturity

12-13

Chapter 12 - Principles of Bond Valuation and Investment

Margin purchase
17. a. Assume an investor purchases a 10-year, $1,000 bond with a coupon rate of 12
percent. The market rate almost immediately falls to 9 percent. What would be the
percentage return on the investment if the buyer borrowed part of the funds with a 25
percent margin requirement? Assume the interest payments on the bond cover the interest
expense on the borrowed funds. (You can use Table 123 in this problem to determine the
new value of the bond.)
b. Assume the same bond in part a is purchased with 25 percent margin, but market rates
go up to 14 percent from 12 percent instead of going down to 9 percent. You can once
again use Table 123 on page 317 to determine the price of the bond. What is the
percentage loss on the cash investment?
12-17. a) The new bond price is $1,195.10 (Table 12-3 for 10 periods with a 12 percent
coupon rate and a 9 percent yield to maturity)
Original bond price

$1,000.00

Increase in value

$ 195.10

Investment (25% margin) = 25% $1000 = $250


Return on investment

Return
$195.10

78.04%
Investment $250.00

b) New bond price


$894.10
(Table 12-3 for 10 periods with a 12 percent
coupon rate and a 14 percent yield to maturity)
Original bond price

$1,000.00

Decrease in value

$ 105.90

Loss on investment

Loss
$105.90

(42.36)%
Investment $250.00

12-14

Chapter 12 - Principles of Bond Valuation and Investment

Deep discount bond


18. Assume an investor is trying to choose between purchasing a deep discount bond or a
par value bond. The deep discount bond pays 6 percent interest, has 20 years to maturity,
and is currently trading at $656.80 with a 10 percent yield to maturity. It is callable at
$1,050.
The second bond is selling at its par value of $1,000. It pays 12 percent interest and has
20 years to maturity. Its yield to maturity is also 12 percent. The bond is callable at
$1,080.
a. If the yield to maturity on the deep discount bond goes down by 2 percent to 8 percent,
what will the new price of the bond be? Do semiannual analysis.
b. If the yield to maturity on the par value bond goes down by 2 percent to 10 percent,
what will the new price of the bond be? Do semiannual analysis.
c. Based on the facts in the problem and your answers to parts a and which bond appears
to be the better purchase? (Consider the call feature as well as capital appreciation.)
12-18. a) PV of $30 semiannually for n = 40 and i = 4%
(Table 12-1 or Appendix D)

$30 19.793 = $593.79

PV of $1,000 for n = 40 and i = 4%


(Table 12-2 or Appendix C)
$1, 000 .208 208.00
$801.79
b) PV of $60 semiannually for n = 40 and i = 5%
(Table 12-1 or Appendix D)

$60 17.160 = $1,029.60

PV of $1,000 for n = 40 and i = 5%


$1, 000 .142

(Table 12-2 or Appendix C)

Bond price

142.00
$1,171.60

c) The deep discount bond is probably the better purchase because a call price of
$1,050 will have no influence on the increase in the bond value. The par value
bond is callable to $1,080 and this may hold down the potential price appreciation
of the bond.
Even if both bonds increase in value as indicated in parts (a) and (b), the deep
discount bond will have the larger percentage gain.

12-15

Chapter 12 - Principles of Bond Valuation and Investment

Deep Discount Bond


New value (Part A)

$801.79

Original value 656.80


Gain in value $144.99
Gain in value $144.99
Original value $656.80
Return = $144.99/$656.80 = 22.08%
Par Value Bond
New value (Part B)

$1,171.60

Original value 1,000.00


Gain in value $ 171.60
Gain in value $ 171.60 = 17.16%
Original value $1,000.00
Return = $171.60/$1,000 = 17.16%
Solution to Investment Advisor Problem
a. Robert Walker failed to follow rule 5, which states that low-coupon rate bonds are
more sensitive to interest rate changes than high coupon rate bonds (this same
principle can be expressed through rule 6 as well in terms of yield to maturity.
Low coupon U.S. government bonds have the greatest price sensitivity because
there is no credit risk, and they are exclusively influenced by interest rates.
Conversely, high coupon rate bonds (so called junk bonds if their rating is below
the first four rating categories are influenced by a multitude of factors. These
include earnings outlook, competitive conditions, potential lawsuits, etc. They
may well be more influenced by these factors than interest rate changes.
This
generally makes them a poor candidate for interest rate plays.
b.

He was selling bonds for a profit before the required 12-month holding period to
qualify for a long-term capital gain favorable tax rate. That maximum rate is 15
percent as opposed to 35 percent for short-term capital gains.

12-16