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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.

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Seniority usually is specified in the indenture contract. Most corporate bond issues have a call provision to buy back outstanding bonds at a specified price before the bonds mature. Ownership of the equipment remains with the trustee appointed to represent the certificate holders. (b) Traditional Fixed-Price Call Provisions: → From an investor’s point of view. The seniority is usually protected by a negative pledge clause. A bond indenture is a formal written agreement between the corporation and the bondholders that spells out the rights and obligations of both parties. A corporation may have several different bond issues outstanding. Call Provisions (a) Bond Refunding: Process of calling an outstanding bond issue and refinancing it with a new bond issue. 2. and these issues normally are differentiated according to the seniority of their claims on the firm's assets. the issuer forces bondholders to surrender their bonds in exchange for the fixed call price. The firm may want to call high-interest bonds and replace them with lower-interest bonds when interest rates decrease. Bond Indentures: This is a description of the contractual terms of a new bond issue included in a bond's prospectus. the corporation is able to issue new bonds that only pay 8 percent coupons. callable bonds are less attractive to investors than non-callable bonds. A non-callable bond has the 2 .2 4. suppose an investor is currently holding bonds paying 10 percent coupons. C. If instead the bonds were non-callable. For example. It is quite lengthy. (b) Subordinated Debentures: Bonds that have a claim on the firm's assets after those with a higher claim have been satisfied. Callable bonds are not as attractive to an investor. There are two major types of call provisions: traditional fixed-price and make-whole. its operations. By calling existing 10 percent coupon bonds. For this reason. railroads. after a fall in market interest rates. Consequently. so they should sell at a lower price. Prospectus: Document prepared as part of a security offering detailed information about a company's financial position. and investment plans. But this happens at a time when the bondholders can reinvest funds only at lower interest rates. so many investors refer to the indenture summary in the prospectus. Bond Seniority Provisions (a) Senior Debentures: Bonds that have a higher claim on the firm's assets than other bonds. which prohibits a new issue of debt with seniority above a currently outstanding issue. a fixed-price call provision has a distinct disadvantage. ( c) Negative Pledge Clause: Bond indenture provision that prohibits new debt from being issued with seniority over an existing issue. The Trust Indenture Act of 1939 requires that any bond issue subject to SEC regulation must have a trustee appointed to represent the bondholders. Equipment trust certificates represent debt issued by a trustee to purchase heavy industrial equipment that is leased and used by airlines. Equipment Trust Certificate: →Shares in a trust with income from a lease contract. Further suppose that. etc. the bondholders would continue to receive the original 10 percent coupons. 1. a callable bond will sell at a lower price than a comparable non-callable bond.

pre-specified make-whole premium. However. As interest rates decrease. the call price paid to bondholders changes over time. the maximum price of an unprotected fixed-price callable bond is generally bounded above by its call price. These bonds are also called extendible bonds. these bonds exhibit the standard convex price-yield relationship in all yield regions. that is. Like a fixed-price call provision. When the price-yield curve is bowed to the origin this is called positive convexity. make-whole call provisions typically specify that the minimum amount received by a bondholder is the par value of the bond. the price of bonds with a make-whole call provision will increase. bondholders receive approximately what the bond is worth if the bond is called. (c) Effective Duration: For standard bonds. The discount rate used to calculate the present value is usually equal to the yield of a comparable maturity U. but it is bowed away from the origin in the region of low yields. ( c) Make-Whole Call Provision: → In just the last few years. Because the yield of a comparable U. has become common in the corporate bond market. a make-whole call provision allows the borrower to pay off the remaining debt early.3 standard convex price-yield relationship.S. the price-yield curve is bowed toward the origin. these fail to account for embedded options in bonds. In contrast. (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. for callable bonds the effective duration is more relevant. a new type of call provision. Thus. 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. Treasury security plus a fixed. Unlike a fixed-price call provision. the make-whole call price decreases. recall that bond prices with a fixed price call provision exhibit negative convexity in the region of low yields. That is. the bondholder is “made whole” when the bond is called. that is. ( e) Convertible Bonds: Bonds that can be exchanged for common stock according to a pre-specified conversion ratio. however. the make-whole call price increases because the discount rate used to calculate the present value decreases. As interest rates decline. The important terms are: 3 .S. In contrast. Put bonds are "putable” on a series of designated put dates. the fixed-price callable bond has a convex or bowed price-yield relationship in the region of high yields. even in the region of low yields. 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. The important lesson here is that no matter how low market interest rates might fall. In addition. Convertible bonds grant bondholders the right to exchange each bond for a designated number of common stock shares of the issuing firm. As interest rates increase. Treasury security changes over time. a “make-whole” call. Macaulay and modified duration are relevant. If a callable bond has a make-whole call provision. This is called negative convexity. This call provision gets it name because the bondholder does not suffer a loss in the event of a call.

2. Graphical Analysis of Convertible Bond Prices 1. 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. This is also called investment value. the firm may force conversion by calling the bonds when the conversion value has risen 10-15%. equal to the value of a comparable nonconvertible bond. Intrinsic Bond Value: The price below which a convertible bond cannot fall. In-the-Money Bond: A convertible bond whose conversion value is greater than its call price. 3. Exchangeable Bonds: Bonds that can be converted into common stock shares of a company other than the issuer's.4  Conversion ratio: → CR = No. B. 4 .

Preferred Stock: → A security with a claim to dividend payments that is senior to common stock. although almost all corporate bonds pay interest semiannually. Protective covenants in an indenture help protect bondholders from event risk. – Maintain assets in good condition. When there is no indenture. which have a single maturity date. 3. The indenture normally stipulates a sinking fund to repay bondholders through fractional redemptions before maturity. it is in default. D. Sinking Fund Provisions: → A sinking fund provides more security to bondholders. – Provide audited financial information. The firm's trustee either buys back the bonds in the open market or calls the bonds by lottery. Term Bonds: Bonds issued with a single maturity date. but. Preferred stock has features of both bonds and common stock and is 5 . Term bonds. Many bond analysts refer to corporate debt with an indenture as a bond and without as a note. Protective Covenants: Restrictions in a bond indenture designed to protect bondholders. the debt is basically a simple IOU of the corporation. Private placements are sold to one or more parties in a private transaction and are exempt from SEC registration requirements. but it is usually best to negotiate a new debt contract. Bonds Without Indentures (a) Private Placement: A new bond issue sold to one or more parties in private transactions not available to the public. negative and positive. – Limit the amount of new debt – Allow redemption in event of merger or spin-off. a structural or financial change to the firm that will cause deterioration in the credit quality of a bond issue.5 The price of a convertible bond is closely linked to the value of the underlying shares. 4. This relationship is shown in Figure 18. depending on the level of interest rates (bond prices). 2. are the most common corporate bond maturity structure. E. an indenture is not required (Trust Indenture Act of 1939).  Thou shalt: (positive covenants): – Use proceeds from sale of assets for other assets. If a bond is not sold to the general public. The bond indenture states exact payment dates. Coupon Payment Provisions: → Coupon rates are stated on an annual basis.4. – Buy another company’s bonds. Event Risk: The possibility that the issuing corporation will experience a significant change in its bond credit quality. Some examples include:  Thou shalt not (negative covenants): – Pay dividends beyond specified amount. There are two types of protective covenants. since it requires periodic fractional bond issue redemptions. some bondholder will have their bonds called early. Bond Maturity and Principal Payment Provisions 1. If a firm suspends payment of coupon interest. 6. bondholders could demand an acceleration of principal repayment and all past due interest. In the case of default. 5. – Sell more senior debt – Refund an existing bond issue with new bonds paying a lower interest rate. Serial Bonds: Bonds issued with a regular sequence of maturity dates.

2. such as: Duff and Phelps. it usually subscribes to several bond rating agencies for a credit evaluation and credit rating. and they are not deductible. or simply floaters. thereby creating increased pricing volatility. Why Bond Ratings Are Important Prudent Investment Guidelines: Restrictions on investment portfolios stipulating that securities purchased must meet a certain level of safety. and extremely speculative grade. preferred has the following characteristics: Preferred stock does not grant voting rights. Adjustable-rate bonds are also called floating rate or floaters. many financial institutions and pension funds have investment safety requirements. Since the preferred stockholders have a claim to dividend payments that are senior to common stockholders. Moody's Investors Service. but it is often callable. McCarthy. 6 . 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. There are several established rating agencies. In fact. such that the bonds in their portfolios are limited to investment grade bonds with a minimum credit rating. When a corporation sells a new bond issue. Higher spreads are correlated with lower credit ratings.6          sometimes referred to as a hybrid security. G." Typically. Many corporations and individual investors rely on these credit ratings. and Standard and Poor's. Preferred stock normally pays a lower interest rate than bonds. An Alternative to Bond Ratings: Credit spreads measure the required yield above a comparable term Treasury security. Credit Rating: An assessment of the credit quality of a bond issue based on the issuer's financial condition. Crisanti and Maffei. Some preferred stock issues are convertible. Corporations that issue preferred stock must treat the dividends the same as common dividends. Preferred stock has no specified maturity. all unpaid preferred dividends normally become cumulative debt that must be repaid before common dividends are paid. Preferred stockholders are promised a stream of fixed dividend payments. 3. and preferred stock issues allow the issuer to adjust the annual coupon based on current interest rates. It is also called floating-rate bonds. Corporations can exclude at least 70% of the preferred dividends from income taxation. Corporate Bond Credit Ratings 1. Inverse floaters have coupons that change inversely with interest rates. Many bond. Adjustable-rate bonds are often putable at par value. but only after suspending common dividends. the spreads are much more responsive to changes. These ratings apply to a specific bond issue and not to the issuer of the bonds. Management can suspend preferred dividend payments. F. There are three broad categories of bond credit ratings: investment grade. Fitch Investors Service. Further. it is termed "preferred. however. speculative grade. these ratings are not guaranteed and are subject to change. If dividends are suspended. Adjustable-Rate Bonds Adjustable-Rate Bonds: These securities pay coupons that change according to a prespecified rule. note.

08 . How much will the firm need to pay the preferred shareholders per share if the firm also pays a common dividend? Solution: Dividend = $1. corporate bond trades are now reported through TRACE (Trade Reporting and Compliance Engine). are called high-yield or junk bonds. what is the conversion ratio? 2. What is the conversion value? Solution: Conversion value = 22  $46.50  5 = $7. Bonds with a speculative or low credit rating. 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. up-to-date prices on corporate bonds. The preferred stock is valued at $92 a share and the common stock is selling at $31 a share. and a market price of $1.116. A firm had a major fire which hampered operations for the past year. what is the conversion price? Solution: Conversion price = $1. Even though high-yield bonds are riskier.50 for the cumulative preferred shares and $0.000/18 = $55. 1.000/$62.50 = 16 A convertible bond has a par value of $1. they may still be appropriate for a diversified portfolio. High-yield bonds can be fallen angels or original-issue junk.95 for the common shares. the firm discontinued all dividends for one year.38 has a conversion price of $62.000. 4.000 and a market price of $1. At the request of the SEC. These bonds are also called junk bonds. The stock is selling for $46.  Transaction prices are now reported on more than 4. Conversion value = 3  $31 = $93 7 . Bond Market Trading: → An active secondary market exists for corporate bonds to allow investors to buy and sell bonds. TRACE has dramatically improved the information available about bond trades. 5.56 A bond has a conversion ratio of 22. Few selected Problems from Chapter 18. Solution: Conversion ratio = $1.7 4. a $1. about 75% of market volume for investment grade bonds. while the greatest total volume of bond trading occurs on the OTC market.50 A preferred stock has a par value of $100 and is convertible into 3 shares of common stock. Junk bonds offer a yield premium in exchange for the risk associated with their higher default rate. As a result. Bond investors now have a way to get accurate.000 bonds  That is. The normal quarterly payments are $1.14 = $1.50. If the par value is $1. 5.300 different bond issues are listed on the NYSE.14.000 par value.015. What is the conversion value? Solution. 3. Next month. those rated Ba (Moody's) or BB (S&P) or lower. More than 2.038. Bonds are traded on the New York Stock Exchange and the OTC. the firm will resume paying dividends.76. More bonds will be added to TRACE over time H. If the conversion ratio is 18. A bond that is currently selling for $933.

note or bond at maturity is the face value because the face value is paid at maturity. The basic characteristics of T-bills.S. and fractions of a percent are 8 . T-notes. Nonmarketable securities do not allow transfer of registered ownership.S. Treasury security ownership is registered with the U. 5. Also called zeroes. Treasury bond and note prices are quoted on a percentage of par basis. Bonds. 13. 10 years or less. Face Value: Also called redemption value. The value of a bill. 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. The debt is financed through marketable and nonmarketable securities. and marketable security ownership can be transferred when the securities are sold. and STRIPS 3. Government bond Basics: → The U. 6. Savings Bonds.S Treasury manages the debt as the financial agent of the federal government. 2. Treasury Bills. or 10 years – Semiannual coupons  T-bonds – Long-term. U. one year or less: 4. Government Account Series. 4. and State and Local Government Series. 2. Notes. currently at over $2 trillion. Nonmarketable securities include U. federal government is the largest borrower in the world. and Treasury bonds.8 Chapter 19: Government Bonds 1. the larger group of the two. Treasury Bond and Note Prices 1. Acronym for Separate Trading of Registered Interest and Principal of Securities. 5.S Treasury. include Treasury bills. Bid-Ask Spread: The difference between a dealer's bid and ask prices. The U. Marketable securities. T-bonds. or 26weeks – Face value (redemption value) – Sold on a discount basis – Imputed interest  T-notes – Medium-term. Treasury notes. with more than $12 trillion in public debt as of January 2010. Imputed Interest: The interest paid on a Treasury bill determined by the size of its discount from face value.S. Discount Basis: This is a method of selling a Treasury bill at a discount from face value. STRIPS: Treasury program allowing investors to buy individual coupon and principal payments from a whole Treasury note or bond. Zero Coupon Bond: A note or bond paying a single cash flow at maturity. Another large market for government debt is municipal government debt. and STRIPS are:  T-bills – Short-term.

the World Bank.000 and are sold at face value.5%/2 = $17. Treasury Auctions Stop-out Bid: The lowest competitive bid in a U. and competitive bids above the stop-out bid are accepted.000. Individual investors can submit noncompetitive bids.50. Since 1985. Six months later. Federal income tax is deferred until the bonds are redeemed.S Treasury has issued inflation-indexed securities. Six months later.S. except that bids are made on a yield basis. Series EE bonds resemble zero-coupon bonds and pay semiannual interest accruals. The competitive bids specify a bid price and quantity. the coupon payment will change. the U. twoyear notes are auctioned monthly.020. 2. C. Federal Government Agency Securities: → Most U. although there is not an 9 .9 stated in thirty-seconds. and the Tennessee Valley Authority. The interest is paid as an accrual to the bond redemption value. the price at which all competitive bids are sufficient to finance the issue amount. For example. the note will pay a coupon of $1. Series EE Savings Bonds: → Series EE bonds are available in face values from $25 to $10. D. which add to the bond's redemption value. Because T-bonds and notes pay interest semiannually. Treasury Inflation-Protected Securities: → In recent years. 2. All noncompetitive bids and accepted competitive bids pay the stop-out bid. Savings bonds (as with all U.S.020 × 3. U.5 percent and an initial principal of $1. 3. the price and yield are calculated using the bond price formula discussed in earlier chapters. T-notes. the Treasury has only issued noncallable bonds.000.S Treasury auction that is accepted.S.000 × 3. the Treasury sets the interest rate at a fixed rate plus the recent inflation rate. U. Savings Bonds 1.5%/2 = $17. longer maturity notes are auctioned each quarter. Assuming 2 percent inflation over the six months since issuance. since the price will be determined by the results of the competitive bid process. which obtains funds from the U.S government agencies consolidate their borrowing through the Federal Financing Bank. the note pays $1.000 × 102% = $1. Several agencies issue directly to the public. suppose an inflation-indexed note is issued with a coupon rate of 3. The bid process is similar for T-bond and T-note issues. The Federal Reserve Bank regularly conducts auctions for T-bills. These bonds share an almost equal credit quality with U. which pay a fixed coupon rate on their current principal and adjust their principal semiannually according to the most recent inflation rate. Treasury. Semiannually. Price and yield information for inflation-indexed Treasury securities is reported in The Wall Street Journal in the same section as other Treasury securities. including: the Resolution Trust Funding Corporation. The Fed accepts sealed bids of two types: competitive and noncompetitive. Also. Series I Savings Bonds: → Series I bonds are sold in face values from $50 to $10. 52-week T-bills are auctioned every four weeks. and T-bonds are sold three times per quarter. and -T-bonds. the note’s principal is then increased to $1. but only Treasury security dealers can submit competitive bids. Noncompetitive bids specify a quantity.85.S Treasury issues. Treasury securities) are not subject to state or local taxes. 13and 26-week T-bills are auctioned weekly. The stop-out bid is determined. with the original price at one-half the face value. Lecture Tip: You will have to point out (very carefully) to students that while the coupon rate remains the same. and its principal is again adjusted to compensate for recent inflation.S.

These notes and bonds are attractive because they pay higher yields than comparable U. and the call price usually includes a call premium. Since 1983. but dealers commonly use yield quotes." Coupon interest is usually exempt from federal income tax. They are also called floaters. (d) Variable-Rate Notes: Securities that pay an interest rate that changes according to market conditions. some munis are putable and others are variable-rate. Inverse floaters are like variable-rate bonds. Yields on “munis” are less than comparable corporate debt. Hybrid Bonds: Municipal bonds secured by project revenue with some form of general obligation credit guarantee. Municipal bonds are typically callable.S. and most states exempt interest from state income tax if the bond is issued in that state. (c) Put Bonds: Bonds that can be sold back to the issuer.000. Municipal debt often has a high credit rating. General Obligation Bonds (GOs): Bonds issued by municipality that are secured by the full faith and credit of the issuer. Revenue bonds are secured by the proceeds collected from the projects they finance. F. E. Also. but some are term bonds with a sinking fund provision. (c ) Term Bonds: Bonds from an issue with a single maturity date. 3." "Limited tax bonds” occur when a constitutional limit is placed on the power of the municipality to assess taxes. They are also called "unlimited tax bonds. Municipal Bonds: Municipal notes and bonds are issued by state and local governments or agencies. and have a par value of $5. government guarantee. Most municipal bonds are callable. Also. and they constitute the bulk of all municipal bonds. all newly issued municipal bonds have had to be registered. Default Risk: The risk that a bond issuer will cease making scheduled payments of coupons or principal. They are issued by all levels of municipal governments and secured by the general taxing powers of the municipalities. but with additional credit guarantees. or both. but they usually have a period of call protection. 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. There are two basic types of municipal bonds: revenue bonds and general obligation bonds (GOs). and they are often called "munis." or "full faith and credit bonds.10 explicit U. Types of Municipal Bonds 1. so bid-ask spreads are higher. A hybrid bond is a revenue bond secured by project-specific cash flows. 10 . 2. Prices are stated as a percent of par value. (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. pay semiannual coupons. These tax advantages make muni bonds attractive to investors in higher income tax brackets.S. Revenue Bonds: Municipal bonds secured by revenues collected from a specific project or projects. The market for these securities is less active. 1. agency bonds are subject to state and local taxation in addition to federal taxation but treasury securities are only subject to federal taxation. Treasury securities. but default risk does exist. but they pay a variable coupon rate that moves inversely with market interest rates. Most munis are issued as serial bonds. 2.

These insurance policies are written by a commercial insurance company. Standard & Poor's Corporation. What is the bond's dollar price? Solution: Price = $30.60 11 . The three largest agencies include: Moody's Investor's Service. Municipal Bond Credit Ratings Municipal bond credit rating agencies provide investors with an assessment of the credit quality of the bond issues. H. (c) Equivalent Taxable Yield To compare corporate and municipal bonds. (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. Few Selected Problems: 1.02625 = $30.000 and a quoted price of 102:20. and Fitch Investors Service.  Writing policies across a wide geographic area. A Treasury bond has a face value of $30.062.787. Many municipalities obtain bond insurance for new bond issues. The credit ratings assigned to a particular bond issue may differ slightly across credit rating agencies.000  102 and 20/32nds percent = $30. Interest is tax-exempt only if the bond issue falls into a qualified category.000  100 and 10/32nds percent = $20. The 1986 Tax Reform Act imposed restrictions on the types of municipal bonds that qualify for federal tax exemption of interest payments.Marginal tax rate) To calculate the investor indifference point: Critical marginal tax rate = 1 .00313 = $20. an investor must compare the yields on an equivalent tax basis. The cost of the policy is paid by the issuer. The insurance usually results in a higher credit rating. What is the amount you will receive if you sell your bond that has a par value of $20. 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.Marginal tax rate) or After-tax yield = Taxable yield x (1 .000  1.50 2. as follows: Equivalent taxable yield = Tax-exempt yield / (1 . Maintaining substantial investment portfolios as a source of financial reserves.11 G. usually due to differing credit rating methods.000? Solution: Sale price = $20. 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. A Treasury bond has a quoted bid price of 100:10 and a quoted ask price of 100:11.000  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.

0675 → 0.082  (1 .31) = 5.0876 -0. Municipal bonds are yielding 4.000 par value and a market value of $7.9 percent if they are uninsured.0657 = .You have a marginal tax rate of 31 percent and an average tax rate of 28 percent.6 percent if they are insured and 4. What is the critical marginal tax rate? Solution : Critical marginal tax rate = 1 . Jeff owns a taxable bond portfolio which is yielding 8.036/(1 .10 percent 7..0876x=0. . Municipal bonds in your area are yielding 3. You own a corporate bond which is yielding 8.048/.5 percent when municipal bonds are yielding 5..868 and has a par value of $50.31) = 7.(.0876 =0.1 percent.12 3.0876 0. What is your after-tax yield if your marginal tax rate is 28 percent? Solution: After-tax yield = .13 percent 12 .28) = 5.67 percent Equivalent taxable yield = . What is the corporate bond yield? Solution : . The time to maturity is 5 years.x).049/(1 . A corporate bond is yielding 6.22 percent 6.2 percent.5 percent coupon Treasury bond that matures in 20 years.25 =25%. Your marginal tax rate is 31 percent.. An investor has a critical marginal tax rate of 28.069) = 30 percent 10. What is his marginal tax rate? Solution: .90 percent 8. His after-tax yield is 6.000.9 percent and a municipal bond is yielding 4.0876x = 0.0657 = 0.0219 → x = 0. x = 25 percent 9.050. The STRIPS is priced at $22.31) = 6.(.8 percent.0876  (1 . What is the yield to maturity? Solution: 4.57 percent. What is the yield to maturity on the STRIPS? Solution: 5.046/(1 .. What is your equivalent taxable yield? Solution: Equivalent taxable yield = .0876x → 0.285 = 1 . Solution: Equivalent taxable yield = .6 percent. → 0. A STRIPS has a $9. Your equivalent taxable yield on the insured bonds is _____ percent and on the uninsured bonds is _____ percent. x = 7.76 percent.0219/0. You own a principal STRIPS which is based on a 4.051/x).

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