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$, this spread will decrease. "his 4uestion is an e#a ple of the spread widenin$.

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