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FIN5558.01 INVESTMENTS Session #3 (Test2) Prof. Kofi Amoateng Chapter 18 & 19: Corporate bonds & Government bonds
Commentary: Bonds are a major source of capital used by Corporations. Chapter 18 includes the following: (a) The basic types of corporate bonds, (b) how callable bonds function, (c) the different types of corporate bonds, and (d) the basics of bond ratings. Chapter 19 includes the following: (a) The basics of U.S. Treasury securities and how they are sold, (b) the workings of the STRIPS program and pricing Treasury bonds, (c) how federal agencies borrow money, and (d) how municipalities borrow money. A. Corporate Bond Basics 1. Plain Vanilla (or Bullet) Bonds: Bonds issued with a relatively standard set of features. 2. Unsecured Debt: Bonds, notes, or other debt issued with no specific collateral pledged as security for the bond issue. Corporate bonds represent the debt of a corporation owed to its bondholders. The fixed sum paid at maturity is the principal, par value, or face value, and the periodic interest payments are coupons. The three main differences between corporate bonds and stock are: Common stock is an ownership claim on the corporate, whereas bonds represent a creditor's claim on the corporation. Coupons and principal, the promised cash flows, are stated in advance, whereas the amount and timing of stock dividends may change at any time. Most corporate bonds are callable, whereas common stock is almost never callable.

There are several trillion dollars in the corporate bond market, with the largest investors being life insurance companies. Every bond issue has specific terms associated with it, from relatively simple to fairly complex. Bonds issued with standard, relatively simple features are called plain vanilla bonds. B. Types of Corporate Bonds 1. Debentures: Unsecured bonds issued by a corporation. Debentures are the most frequently issued corporate bond, and they represent an unsecured legal claim on the corporation. In the event of default, the bondholder's claim extends to all assets, although they may have to share this claim with other creditors. 2. Mortgage Bonds: Debt secured with a property lien. Mortgage bonds represent debt with a lien on specific property, and the bondholder has the legal right to foreclose on the property, although it may be more advantageous to renegotiate. 3. Collateral Trust Bond: Debt secured with financial collateral. Collateral trust bonds represent a pledge of financial assets as security and are usually issued by holding companies.

4. Equipment Trust Certificate: Shares in a trust with income from a lease contract. Equipment trust certificates represent debt issued by a trustee to purchase heavy industrial equipment that is leased and used by airlines, railroads, etc. Ownership of the equipment remains with the trustee appointed to represent the certificate holders. C. Bond Indentures: This is a description of the contractual terms of a new bond issue included in a bond's prospectus. Prospectus: Document prepared as part of a security offering detailed information about a company's financial position, its operations, and investment plans. A bond indenture is a formal written agreement between the corporation and the bondholders that spells out the rights and obligations of both parties. It is quite lengthy, so many investors refer to the indenture summary in the prospectus. The Trust Indenture Act of 1939 requires that any bond issue subject to SEC regulation must have a trustee appointed to represent the bondholders. 1. Bond Seniority Provisions (a) Senior Debentures: Bonds that have a higher claim on the firm's assets than other bonds. (b) Subordinated Debentures: Bonds that have a claim on the firm's assets after those with a higher claim have been satisfied. ( c) Negative Pledge Clause: Bond indenture provision that prohibits new debt from being issued with seniority over an existing issue. A corporation may have several different bond issues outstanding, and these issues normally are differentiated according to the seniority of their claims on the firm's assets. Seniority usually is specified in the indenture contract. The seniority is usually protected by a negative pledge clause, which prohibits a new issue of debt with seniority above a currently outstanding issue. 2. Call Provisions (a) Bond Refunding: Process of calling an outstanding bond issue and refinancing it with a new bond issue. Most corporate bond issues have a call provision to buy back outstanding bonds at a specified price before the bonds mature. The firm may want to call high-interest bonds and replace them with lower-interest bonds when interest rates decrease. Callable bonds are not as attractive to an investor, so they should sell at a lower price. There are two major types of call provisions: traditional fixed-price and make-whole. (b) Traditional Fixed-Price Call Provisions: From an investors point of view, a fixed-price call provision has a distinct disadvantage. For example, suppose an investor is currently holding bonds paying 10 percent coupons. Further suppose that, after a fall in market interest rates, the corporation is able to issue new bonds that only pay 8 percent coupons. By calling existing 10 percent coupon bonds, the issuer forces bondholders to surrender their bonds in exchange for the fixed call price. But this happens at a time when the bondholders can reinvest funds only at lower interest rates. If instead the bonds were non-callable, the bondholders would continue to receive the original 10 percent coupons. For this reason, callable bonds are less attractive to investors than non-callable bonds. Consequently, a callable bond will sell at a lower price than a comparable non-callable bond. A non-callable bond has the
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standard convex price-yield relationship, that is, the price-yield curve is bowed toward the origin. When the price-yield curve is bowed to the origin this is called positive convexity. In contrast, the fixed-price callable bond has a convex or bowed price-yield relationship in the region of high yields, but it is bowed away from the origin in the region of low yields. This is called negative convexity. The important lesson here is that no matter how low market interest rates might fall, the maximum price of an unprotected fixed-price callable bond is generally bounded above by its call price. ( c) Make-Whole Call Provision: In just the last few years, a new type of call provision, a make-whole call, has become common in the corporate bond market. If a callable bond has a make-whole call provision, bondholders receive approximately what the bond is worth if the bond is called. This call provision gets it name because the bondholder does not suffer a loss in the event of a call; that is, the bondholder is made whole when the bond is called. Like a fixed-price call provision, a make-whole call provision allows the borrower to pay off the remaining debt early. Unlike a fixed-price call provision, however, a make-whole call provision requires the borrower to make a lump-sum payment representing the present value of all payments that will not be made because of the call. The discount rate used to calculate the present value is usually equal to the yield of a comparable maturity U.S. Treasury security plus a fixed, pre-specified make-whole premium. Because the yield of a comparable U.S. Treasury security changes over time, the call price paid to bondholders changes over time. As interest rates decrease, the make-whole call price increases because the discount rate used to calculate the present value decreases. As interest rates increase, the make-whole call price decreases. In addition, make-whole call provisions typically specify that the minimum amount received by a bondholder is the par value of the bond. As interest rates decline, even in the region of low yields, the price of bonds with a make-whole call provision will increase. That is, these bonds exhibit the standard convex price-yield relationship in all yield regions. In contrast, recall that bond prices with a fixed price call provision exhibit negative convexity in the region of low yields. (c) Effective Duration: For standard bonds, Macaulay and modified duration are relevant. However, these fail to account for embedded options in bonds. Thus, for callable bonds the effective duration is more relevant. (d) Put Bonds: A bond that can be sold back to the issuer at a prespecified price on any of a sequence of prespecified dates. These bonds are also called extendible bonds. Put bonds are "putable on a series of designated put dates. The put feature creates a floor on the market price of the bond, and it also protects bondholders from corporate acts that may hurt credit quality. ( e) Convertible Bonds: Bonds that can be exchanged for common stock according to a pre-specified conversion ratio. Convertible bonds grant bondholders the right to exchange each bond for a designated number of common stock shares of the issuing firm. The important terms are:

Conversion ratio: CR = No. of stock shares acquired by conversion Conversion price: CP = Bond par value / Conversion ratio Conversion value: CV = Price per share of stock x Conversion ratio When is the optimum time to convert? The rational decision is to postpone converting as long as possible because the investor will want to receive as many coupon payments as possible. If the bonds are callable, the firm may force conversion by calling the bonds when the conversion value has risen 10-15%. B. Graphical Analysis of Convertible Bond Prices

1. In-the-Money Bond: A convertible bond whose conversion value is greater than its call price. 2. Intrinsic Bond Value: The price below which a convertible bond cannot fall, equal to the value of a comparable nonconvertible bond. This is also called investment value. 3. Exchangeable Bonds: Bonds that can be converted into common stock shares of a company other than the issuer's.

The price of a convertible bond is closely linked to the value of the underlying shares. This relationship is shown in Figure 18.4. D. Bond Maturity and Principal Payment Provisions 1. Term Bonds: Bonds issued with a single maturity date. 2. Serial Bonds: Bonds issued with a regular sequence of maturity dates. Term bonds, which have a single maturity date, are the most common corporate bond maturity structure. The indenture normally stipulates a sinking fund to repay bondholders through fractional redemptions before maturity. 3. Sinking Fund Provisions: A sinking fund provides more security to bondholders, but, since it requires periodic fractional bond issue redemptions, some bondholder will have their bonds called early. The firm's trustee either buys back the bonds in the open market or calls the bonds by lottery, depending on the level of interest rates (bond prices). 4. Coupon Payment Provisions: Coupon rates are stated on an annual basis, although almost all corporate bonds pay interest semiannually. The bond indenture states exact payment dates. If a firm suspends payment of coupon interest, it is in default. In the case of default, bondholders could demand an acceleration of principal repayment and all past due interest, but it is usually best to negotiate a new debt contract. 5. Protective Covenants: Restrictions in a bond indenture designed to protect bondholders. There are two types of protective covenants, negative and positive. Some examples include: Thou shalt not (negative covenants): Pay dividends beyond specified amount. Sell more senior debt Refund an existing bond issue with new bonds paying a lower interest rate. Buy another companys bonds. Thou shalt: (positive covenants): Use proceeds from sale of assets for other assets. Limit the amount of new debt Allow redemption in event of merger or spin-off. Maintain assets in good condition. Provide audited financial information. Event Risk: The possibility that the issuing corporation will experience a significant change in its bond credit quality. Protective covenants in an indenture help protect bondholders from event risk, a structural or financial change to the firm that will cause deterioration in the credit quality of a bond issue. 6. Bonds Without Indentures (a) Private Placement: A new bond issue sold to one or more parties in private transactions not available to the public. If a bond is not sold to the general public, an indenture is not required (Trust Indenture Act of 1939). Private placements are sold to one or more parties in a private transaction and are exempt from SEC registration requirements. When there is no indenture, the debt is basically a simple IOU of the corporation. Many bond analysts refer to corporate debt with an indenture as a bond and without as a note. E. Preferred Stock: A security with a claim to dividend payments that is senior to common stock. Preferred stock has features of both bonds and common stock and is
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sometimes referred to as a hybrid security. Since the preferred stockholders have a claim to dividend payments that are senior to common stockholders, it is termed "preferred." Typically, preferred has the following characteristics: Preferred stock does not grant voting rights. Preferred stockholders are promised a stream of fixed dividend payments. Preferred stock has no specified maturity, but it is often callable. Management can suspend preferred dividend payments, but only after suspending common dividends. If dividends are suspended, all unpaid preferred dividends normally become cumulative debt that must be repaid before common dividends are paid. Some preferred stock issues are convertible. Preferred stock normally pays a lower interest rate than bonds. Corporations can exclude at least 70% of the preferred dividends from income taxation. Corporations that issue preferred stock must treat the dividends the same as common dividends, and they are not deductible.

F. Adjustable-Rate Bonds Adjustable-Rate Bonds: These securities pay coupons that change according to a prespecified rule. It is also called floating-rate bonds, or simply floaters. Many bond, note, and preferred stock issues allow the issuer to adjust the annual coupon based on current interest rates. Adjustable-rate bonds are also called floating rate or floaters. Adjustable-rate bonds are often putable at par value. Inverse floaters have coupons that change inversely with interest rates, thereby creating increased pricing volatility. G. Corporate Bond Credit Ratings 1. Credit Rating: An assessment of the credit quality of a bond issue based on the issuer's financial condition. When a corporation sells a new bond issue, it usually subscribes to several bond rating agencies for a credit evaluation and credit rating. There are several established rating agencies, such as: Duff and Phelps; Fitch Investors Service; McCarthy; Crisanti and Maffei; Moody's Investors Service; and Standard and Poor's. These ratings apply to a specific bond issue and not to the issuer of the bonds. Further, these ratings are not guaranteed and are subject to change. There are three broad categories of bond credit ratings: investment grade, speculative grade, and extremely speculative grade. 2. Why Bond Ratings Are Important Prudent Investment Guidelines: Restrictions on investment portfolios stipulating that securities purchased must meet a certain level of safety. These credit ratings are important because only a few institutional investors have the resources and expertise to properly evaluate a bond's credit quality on their own. Many corporations and individual investors rely on these credit ratings. In fact, many financial institutions and pension funds have investment safety requirements, such that the bonds in their portfolios are limited to investment grade bonds with a minimum credit rating. 3. An Alternative to Bond Ratings: Credit spreads measure the required yield above a comparable term Treasury security. Higher spreads are correlated with lower credit ratings; however, the spreads are much more responsive to changes.
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4. Junk Bonds: High-Yield Bonds: Bonds with a speculative credit rating that is offset by a yield premium offered to compensate for higher credit risk. These bonds are also called junk bonds. Bonds with a speculative or low credit rating, those rated Ba (Moody's) or BB (S&P) or lower, are called high-yield or junk bonds. High-yield bonds can be fallen angels or original-issue junk. Junk bonds offer a yield premium in exchange for the risk associated with their higher default rate. Even though high-yield bonds are riskier, they may still be appropriate for a diversified portfolio. 5. Bond Market Trading: An active secondary market exists for corporate bonds to allow investors to buy and sell bonds. Bonds are traded on the New York Stock Exchange and the OTC. More than 2,300 different bond issues are listed on the NYSE, while the greatest total volume of bond trading occurs on the OTC market. Bond investors now have a way to get accurate, up-to-date prices on corporate bonds. At the request of the SEC, corporate bond trades are now reported through TRACE (Trade Reporting and Compliance Engine). TRACE has dramatically improved the information available about bond trades. Transaction prices are now reported on more than 4,000 bonds That is, about 75% of market volume for investment grade bonds. More bonds will be added to TRACE over time H. Few selected Problems from Chapter 18. 1. A bond that is currently selling for $933.38 has a conversion price of $62.50. If the par value is
$1,000, what is the conversion ratio?

2.

3.

4.

5.

Solution: Conversion ratio = $1,000/$62.50 = 16 A convertible bond has a par value of $1,000 and a market price of $1,116.76. If the conversion ratio is 18, what is the conversion price? Solution: Conversion price = $1,000/18 = $55.56 A bond has a conversion ratio of 22, a $1,000 par value, and a market price of $1,038. The stock is selling for $46.14. What is the conversion value? Solution: Conversion value = 22 $46.14 = $1,015.08 . A firm had a major fire which hampered operations for the past year. As a result, the firm discontinued all dividends for one year. Next month, the firm will resume paying dividends. The normal quarterly payments are $1.50 for the cumulative preferred shares and $0.95 for the common shares. How much will the firm need to pay the preferred shareholders per share if the firm also pays a common dividend? Solution: Dividend = $1.50 5 = $7.50 A preferred stock has a par value of $100 and is convertible into 3 shares of common stock. The preferred stock is valued at $92 a share and the common stock is selling at $31 a share. What is the conversion value? Solution; Conversion value = 3 $31 = $93

Chapter 19: Government Bonds 1. Government bond Basics: The U.S. federal government is the largest borrower in the world, with more than $12 trillion in public debt as of January 2010. The U.S Treasury manages the debt as the financial agent of the federal government. The debt is financed through marketable and nonmarketable securities. Marketable securities, the larger group of the two, include Treasury bills, Treasury notes, and Treasury bonds. Nonmarketable securities include U.S. Savings Bonds, Government Account Series, and State and Local Government Series. Treasury security ownership is registered with the U.S Treasury, and marketable security ownership can be transferred when the securities are sold. Nonmarketable securities do not allow transfer of registered ownership. Another large market for government debt is municipal government debt, currently at over $2 trillion. 2. U.S. Treasury Bills, Notes, Bonds, and STRIPS 3. Face Value: Also called redemption value. The value of a bill, note or bond at maturity is the face value because the face value is paid at maturity. 4. Discount Basis: This is a method of selling a Treasury bill at a discount from face value. Imputed Interest: The interest paid on a Treasury bill determined by the size of its discount from face value. 5. STRIPS: Treasury program allowing investors to buy individual coupon and principal payments from a whole Treasury note or bond. Acronym for Separate Trading of Registered Interest and Principal of Securities. 6. Zero Coupon Bond: A note or bond paying a single cash flow at maturity. Also called zeroes. The basic characteristics of T-bills, T-notes, T-bonds, and STRIPS are: T-bills Short-term, one year or less: 4, 13, or 26weeks Face value (redemption value) Sold on a discount basis Imputed interest T-notes Medium-term, 10 years or less; 2, 5, or 10 years Semiannual coupons T-bonds Long-term, 30 years (note: no longer auctioned) Semiannual coupons STRIPS From T-notes and T-bonds Separate Trading of Registered Interest and Principal of Securities (STRIPS) Coupon strips and principal strips Effectively become zero coupon bonds B. Treasury Bond and Note Prices 1. Bid-Ask Spread: The difference between a dealer's bid and ask prices. Treasury bond and note prices are quoted on a percentage of par basis, and fractions of a percent are
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stated in thirty-seconds. Since 1985, the Treasury has only issued noncallable bonds. Because T-bonds and notes pay interest semiannually, the price and yield are calculated using the bond price formula discussed in earlier chapters. 2. Treasury Inflation-Protected Securities: In recent years, the U.S Treasury has issued inflation-indexed securities, which pay a fixed coupon rate on their current principal and adjust their principal semiannually according to the most recent inflation rate. For example, suppose an inflation-indexed note is issued with a coupon rate of 3.5 percent and an initial principal of $1,000. Six months later, the note will pay a coupon of $1,000 3.5%/2 = $17.50. Assuming 2 percent inflation over the six months since issuance, the notes principal is then increased to $1,000 102% = $1,020. Six months later, the note pays $1,020 3.5%/2 = $17.85, and its principal is again adjusted to compensate for recent inflation. Lecture Tip: You will have to point out (very carefully) to students that while the coupon rate remains the same, the coupon payment will change. Price and yield information for inflation-indexed Treasury securities is reported in The Wall Street Journal in the same section as other Treasury securities. 3. U.S. Treasury Auctions Stop-out Bid: The lowest competitive bid in a U.S Treasury auction that is accepted. The Federal Reserve Bank regularly conducts auctions for T-bills, T-notes, and -T-bonds. 13and 26-week T-bills are auctioned weekly, 52-week T-bills are auctioned every four weeks, twoyear notes are auctioned monthly, longer maturity notes are auctioned each quarter, and T-bonds are sold three times per quarter. The Fed accepts sealed bids of two types: competitive and noncompetitive. The competitive bids specify a bid price and quantity. Noncompetitive bids specify a quantity, since the price will be determined by the results of the competitive bid process. The stop-out bid is determined, the price at which all competitive bids are sufficient to finance the issue amount, and competitive bids above the stop-out bid are accepted. All noncompetitive bids and accepted competitive bids pay the stop-out bid. Individual investors can submit noncompetitive bids, but only Treasury security dealers can submit competitive bids. The bid process is similar for T-bond and T-note issues, except that bids are made on a yield basis. C. U.S. Savings Bonds 1. Series EE Savings Bonds: Series EE bonds are available in face values from $25 to $10,000, with the original price at one-half the face value. Series EE bonds resemble zero-coupon bonds and pay semiannual interest accruals, which add to the bond's redemption value. 2. Series I Savings Bonds: Series I bonds are sold in face values from $50 to $10,000 and are sold at face value. Semiannually, the Treasury sets the interest rate at a fixed rate plus the recent inflation rate. The interest is paid as an accrual to the bond redemption value. Savings bonds (as with all U.S. Treasury securities) are not subject to state or local taxes. Also, Federal income tax is deferred until the bonds are redeemed. D. Federal Government Agency Securities: Most U.S government agencies consolidate their borrowing through the Federal Financing Bank, which obtains funds from the U.S. Treasury. Several agencies issue directly to the public, including: the Resolution Trust Funding Corporation, the World Bank, and the Tennessee Valley Authority. These bonds share an almost equal credit quality with U.S Treasury issues, although there is not an
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explicit U.S. government guarantee. These notes and bonds are attractive because they pay higher yields than comparable U.S. Treasury securities. The market for these securities is less active, so bid-ask spreads are higher. Also, agency bonds are subject to state and local taxation in addition to federal taxation but treasury securities are only subject to federal taxation. E. Municipal Bonds: Municipal notes and bonds are issued by state and local governments or agencies, and they are often called "munis." Coupon interest is usually exempt from federal income tax, and most states exempt interest from state income tax if the bond is issued in that state. These tax advantages make muni bonds attractive to investors in higher income tax brackets. Yields on munis are less than comparable corporate debt. Municipal debt often has a high credit rating, but default risk does exist. 1. Default Risk: The risk that a bond issuer will cease making scheduled payments of coupons or principal, or both. 2. General Obligation Bonds (GOs): Bonds issued by municipality that are secured by the full faith and credit of the issuer. 3. Municipal Bond Features (a) Call provision: Feature of a municipal bond issue that specifies when the bonds may be called by the issuer and the call price that must be paid. (b) Serial Bonds: Bonds issued with maturity dates scheduled at intervals so that a fraction of the bond issue matures in each year of a multiple-year period. (c ) Term Bonds: Bonds from an issue with a single maturity date. (c) Put Bonds: Bonds that can be sold back to the issuer. (d) Variable-Rate Notes: Securities that pay an interest rate that changes according to market conditions. They are also called floaters. Municipal bonds are typically callable, pay semiannual coupons, and have a par value of $5,000. Prices are stated as a percent of par value, but dealers commonly use yield quotes. Most municipal bonds are callable, but they usually have a period of call protection, and the call price usually includes a call premium. Most munis are issued as serial bonds, but some are term bonds with a sinking fund provision. Also, some munis are putable and others are variable-rate. Inverse floaters are like variable-rate bonds, but they pay a variable coupon rate that moves inversely with market interest rates. F. Types of Municipal Bonds 1. Revenue Bonds: Municipal bonds secured by revenues collected from a specific project or projects. 2. Hybrid Bonds: Municipal bonds secured by project revenue with some form of general obligation credit guarantee. There are two basic types of municipal bonds: revenue bonds and general obligation bonds (GOs). They are issued by all levels of municipal governments and secured by the general taxing powers of the municipalities. They are also called "unlimited tax bonds," or "full faith and credit bonds." "Limited tax bonds occur when a constitutional limit is placed on the power of the municipality to assess taxes. Revenue bonds are secured by the proceeds collected from the projects they finance, and they constitute the bulk of all municipal bonds. A hybrid bond is a revenue bond secured by project-specific cash flows, but with additional credit guarantees. Since 1983, all newly issued municipal bonds have had to be registered.

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G. Municipal Bond Credit Ratings Municipal bond credit rating agencies provide investors with an assessment of the credit quality of the bond issues. The three largest agencies include: Moody's Investor's Service, Standard & Poor's Corporation, and Fitch Investors Service. The credit ratings assigned to a particular bond issue may differ slightly across credit rating agencies, usually due to differing credit rating methods. (a) Municipal Bond Insurance (b) Insured Municipal Bonds: Bonds secured by an insurance policy that guarantees bond interest and principal payments should the issuer default. Many municipalities obtain bond insurance for new bond issues. These insurance policies are written by a commercial insurance company. The cost of the policy is paid by the issuer. The insurance usually results in a higher credit rating, which allows the bond to sell at a higher price. Municipal bond insurance companies manage risk by: Insuring bond issues from municipalities with good credit ratings. Writing policies across a wide geographic area. Maintaining substantial investment portfolios as a source of financial reserves. (c) Equivalent Taxable Yield To compare corporate and municipal bonds, an investor must compare the yields on an equivalent tax basis, as follows: Equivalent taxable yield = Tax-exempt yield / (1 - Marginal tax rate) or After-tax yield = Taxable yield x (1 - Marginal tax rate) To calculate the investor indifference point: Critical marginal tax rate = 1 - [(Tax-exempt yield) / Taxable yield] Lecture Tip: Municipal bonds tend to be an investment category that is not as appealing to students. When discussing munis it is important to emphasize the size of the muni market and the tax benefits of investing in munis. (d) Taxable Municipal Bonds Private Activity Bonds: Taxable municipal bonds used to finance facilities used by private businesses. The 1986 Tax Reform Act imposed restrictions on the types of municipal bonds that qualify for federal tax exemption of interest payments. Private activity bonds include any municipal security (1) where 10% or more of the issue finances facilities used by private entities and (2) that is secured by payments from private entities. Interest is tax-exempt only if the bond issue falls into a qualified category. H. Few Selected Problems: 1. A Treasury bond has a face value of $30,000 and a quoted price of 102:20. What is the bond's dollar price? Solution: Price = $30,000 102 and 20/32nds percent = $30,000 1.02625 = $30,787.50 2. A Treasury bond has a quoted bid price of 100:10 and a quoted ask price of 100:11. What is the amount you will receive if you sell your bond that has a par value of $20,000? Solution: Sale price = $20,000 100 and 10/32nds percent = $20,000 1.00313 = $20,062.60
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3. A STRIPS has a $9,000 par value and a market value of $7,050. The time to maturity is 5 years. What is the yield to maturity?

Solution: 4. You own a principal STRIPS which is based on a 4.5 percent coupon Treasury bond that matures in 20 years. The STRIPS is priced at $22,868 and has a par value of $50,000. What is the yield to maturity on the STRIPS?

Solution: 5. .You have a marginal tax rate of 31 percent and an average tax rate of 28 percent. Municipal bonds in your area are yielding 3.6 percent. What is your equivalent taxable yield? Solution: Equivalent taxable yield = .036/(1 - .31) = 5.22 percent 6. Municipal bonds are yielding 4.6 percent if they are insured and 4.9 percent if they are uninsured. Your marginal tax rate is 31 percent. Your equivalent taxable yield on the insured bonds is _____ percent and on the uninsured bonds is _____ percent. Solution: Equivalent taxable yield = .046/(1 - .31) = 6.67 percent Equivalent taxable yield = .049/(1 - .31) = 7.10 percent 7. You own a corporate bond which is yielding 8.2 percent. What is your after-tax yield if your marginal tax rate is 28 percent? Solution: After-tax yield = .082 (1 - .28) = 5.90 percent 8. Jeff owns a taxable bond portfolio which is yielding 8.76 percent. His after-tax yield is 6.57 percent. What is his marginal tax rate? Solution: .0657 = .0876 (1 - x); 0.0657 = 0.0876 -0.0876x 0.0876x=0.0876 0.0675 0.0876x = 0.0219 x = 0.0219/0.0876 =0.25 =25%. x = 25 percent 9. A corporate bond is yielding 6.9 percent and a municipal bond is yielding 4.8 percent. What is the critical marginal tax rate? Solution : Critical marginal tax rate = 1 - (.048/.069) = 30 percent 10. An investor has a critical marginal tax rate of 28.5 percent when municipal bonds are yielding 5.1 percent. What is the corporate bond yield? Solution : .285 = 1 - (.051/x); x = 7.13 percent

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