Chapter 14 - Bond Prices and Yields

CHAPTER14:BONDPRICESANDYIELDS
PROBLEMSETS
1.

Thebondcallableat105shouldsellatalowerpricebecausethecallprovisionismore
valuabletothefirm.Therefore,itsyieldtomaturityshouldbehigher.

2.

Zerocouponbondsprovidenocouponstobereinvested.Therefore,theinvestor'sproceeds
fromthebondareindependentoftherateatwhichcouponscouldbereinvested(ifthey
werepaid).Thereisnoreinvestmentrateuncertaintywithzeros.

3.

Abondscouponinterestpaymentsandprincipalrepaymentarenotaffectedbychanges
inmarketrates.Consequently,ifmarketratesincrease,bondinvestorsinthesecondary
marketsarenotwillingtopayasmuchforaclaimonagivenbondsfixedinterestand
principalpaymentsastheywouldifmarketrateswerelower.Thisrelationshipis
apparentfromtheinverserelationshipbetweeninterestratesandpresentvalue.An
increaseinthediscountrate(i.e.,themarketrate)decreasesthepresentvalueofthe
futurecashflows.

4.

a.

Effectiveannualratefor3monthTbill:
100,000

97,645

b.

1 1.02412 4 1 0.100 10.0%

Effectiveannualinterestrateforcouponbondpaying5%semiannually:
(1.05)21=0.1025or10.25%
Thereforethecouponbondhasthehighereffectiveannualinterestrate.

5.

Theeffectiveannualyieldonthesemiannualcouponbondsis8.16%.Iftheannual
couponbondsaretosellatpartheymustofferthesameyield,whichrequiresanannual
couponrateof8.16%.

6.

Thebondpricewillbelower.Astimepasses,thebondprice,whichisnowabovepar
value,willapproachpar.
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Chapter 14 - Bond Prices and Yields

7.

Yieldtomaturity:Usingafinancialcalculator,enterthefollowing:
n=3;PV=953.10;FV=1000;PMT=80;COMPi
Thisresultsin:YTM=9.88%
Realizedcompoundyield:First,findthefuturevalue(FV)ofreinvestedcouponsand
principal:
FV=($801.101.12)+($801.12)+$1,080=$1,268.16
Thenfindtherate(yrealized)thatmakestheFVofthepurchasepriceequalto$1,268.16:
$953.10(1+yrealized)3=$1,268.16yrealized=9.99%orapproximately10%

8.

a.

b.

Zerocoupon
$463.19

8%coupon
$1,000.00

10%coupon
$1,134.20

$500.25

$1,000.00

$1,124.94

$37.06

$0.00

$9.26

Couponincome

$0.00

$80.00

$100.00

Pretaxincome

$37.06

$80.00

$90.74

Pretaxrateofreturn

8.00%

8.00%

8.00%

Taxes*

$11.12

$24.00

$28.15

Aftertaxincome

$25.94

$56.00

$62.59

Aftertaxrateofreturn

5.60%

5.60%

5.52%

Price1yearfromnow

$543.93

$1,065.15

$1,195.46

$80.74

$65.15

$61.26

Couponincome

$0.00

$80.00

$100.00

Pretaxincome

$80.74

$145.15

$161.26

17.43%

14.52%

14.22%

Taxes**

$19.86

$37.03

$42.25

Aftertaxincome

$60.88

$108.12

$119.01

13.14%

10.81%

10.49%

Currentprices
Price1yearfromnow
Priceincrease

c.

Priceincrease

Pretaxrateofreturn

Aftertaxrateofreturn

14-2

Chapter 14 - Bond Prices and Yields

*Incomputingtaxes,weassumethatthe10%couponbondwasissuedatparand
thatthedecreaseinpricewhenthebondissoldatyearendistreatedasacapital
lossandthereforeisnottreatedasanoffsettoordinaryincome.
**Incomputingtaxesforthezerocouponbond,$37.06istaxedasordinary
income(seepart(b))andtheremainderofthepriceincreaseistaxedasacapital
gain.
9.

a.

Onafinancialcalculator,enterthefollowing:
n=40;FV=1000;PV=950;PMT=40
Youwillfindthattheyieldtomaturityonasemiannualbasisis4.26%.This
impliesabondequivalentyieldtomaturityequalto:4.26%2=8.52%
Effectiveannualyieldtomaturity=(1.0426)21=0.0870=8.70%

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Chapter 14 - Bond Prices and Yields

b.

Sincethebondissellingatpar,theyieldtomaturityonasemiannualbasisisthe
sameasthesemiannualcouponrate,i.e.,4%.Thebondequivalentyieldto
maturityis8%.
Effectiveannualyieldtomaturity=(1.04)21=0.0816=8.16%

c.

KeepingotherinputsunchangedbutsettingPV=1050,wefindabond
equivalentyieldtomaturityof7.52%,or3.76%onasemiannualbasis.
Effectiveannualyieldtomaturity=(1.0376)21=0.0766=7.66%

10.

Sincethebondpaymentsarenowmadeannuallyinsteadofsemiannually,thebond
equivalentyieldtomaturityisthesameastheeffectiveannualyieldtomaturity.Usinga
financialcalculator,enter:n=20;FV=1000;PV=price,PMT=80.
Theresultingyieldsforthethreebondsare:
BondPrice
$950
$1,000
$1,050

Bondequivalentyield=
Effectiveannualyield
8.53%
8.00%
7.51%

Theyieldscomputedinthiscasearelowerthantheyieldscalculatedwithsemiannual
payments.Allelseequal,bondswithannualpaymentsarelessattractivetoinvestors
becausemoretimeelapsesbeforepaymentsarereceived.Ifthebondpriceisthesame
withannualpayments,thenthebond'syieldtomaturityislower.
11.
Price
$400.00
$500.00
$500.00
$385.54
$463.19
$400.00
12.

a.

Maturity
(years)
20.00
20.00
10.00
10.00
10.00
11.91

Bondequivalent
YTM
4.688%
3.526%
7.177%
10.000%
8.000%
8.000%

Thebondpays$50every6months.Thecurrentpriceis:
[$50Annuityfactor(4%,6)]+[$1,000PVfactor(4%,6)]=$1,052.42
Assumingthemarketinterestrateremains4%perhalfyear,pricesixmonthsfrom
nowis:
[$50Annuityfactor(4%,5)]+[$1,000PVfactor(4%,5)]=$1,044.52

b.

Rateofreturn

$50 ($1,044.52 $1,052.42) $50 $7.90

$1,052.42
$1,052.42
14-4

Chapter 14 - Bond Prices and Yields

=0.04=4.0%persixmonths

14-5

Chapter 14 - Bond Prices and Yields

13.

Thereportedbondpriceis:1002/32percentofpar=$1,000.625
However,15dayshavepassedsincethelastsemiannualcouponwaspaid,so:
accruedinterest=$35(15/182)=$2.885
Theinvoicepriceisthereportedpriceplusaccruedinterest:$1,003.51

14.

Iftheyieldtomaturityisgreaterthanthecurrentyield,thenthebondoffersthe
prospectofpriceappreciationasitapproachesitsmaturitydate.Therefore,thebond
mustbesellingbelowparvalue.

15.

Thecouponrateislessthan9%.Ifcoupondividedbypriceequals9%,andpriceis
lessthanpar,thenpricedividedbyparislessthan9%.

16.
Time

Inflationin
yearjust
ended

0
1
2
3

2%
3%
1%

Parvalue

Coupon
payment

Principal
repayment

$40.80
$42.02
$42.44

$0.00
$0.00
$1,061.11

$1,000.00
$1,020.00
$1,050.60
$1,061.11

Thenominalrateofreturnandrealrateofreturnonthebondineachyearare
computedasfollows:
Nominalrateofreturn=
Realrateofreturn=
Secondyear

Thirdyear

Nominalreturn

$42.02 $30.60
0.071196
$1,020

$42.44 $10.51
0.050400
$1,050.60

Realreturn

1.071196
1 0.040 4.0%
1.03

1.050400
1 0.040 4.0%
1.01

Therealrateofreturnineachyearispreciselythe4%realyieldonthebond.

14-6

Chapter 14 - Bond Prices and Yields

17.

Thepricescheduleisasfollows:
Year
0(now)
1
2
19
20

Imputedinterest
Remaining Constantyieldvalue
(Increaseinconstant
Maturity(T)
$1,000/(1.08)T
yieldvalue)
20years
$214.55
19
$231.71
$17.16
18
$250.25
$18.54
1
$925.93
0
$1,000.00
$74.07

18.

Thebondisissuedatapriceof$800.Therefore,itsyieldtomaturityis:6.8245%
Therefore,usingtheconstantyieldmethod,wefindthatthepriceinoneyear(when
maturityfallsto9years)willbe(atanunchangedyield)$814.60,representinganincrease
of$14.60.Totaltaxableincomeis:$40.00+$14.60=$54.60

19.

a.

Thebondsellsfor$1,124.72basedonthe3.5%yieldtomaturity.
[n=60;i=3.5;FV=1000;PMT=40]
Therefore,yieldtocallis3.368%semiannually,6.736%semiannually.
[n=10semiannualperiods;PV=1124.72;FV=1100;PMT=40]

20.

b.

Ifthecallpricewere$1,050,wewouldsetFV=1,050andredopart(a)tofind
thatyieldtocallis2.976%semiannually,5.952%annually.Withalowercall
price,theyieldtocallislower.

c.

Yieldtocallis3.031%semiannually,6.602%annually.
[n=4;PV=1124.72;FV=1100;PMT=40]

Thestatedyieldtomaturity,basedonpromisedpayments,equals16.075%.
[n=10;PV=900;FV=1000;PMT=140]
Basedonexpectedcouponpaymentsof$70annually,theexpectedyieldtomaturity
is8.526%.

21.

Thebondissellingatparvalue.Itsyieldtomaturityequalsthecouponrate,10%.Ifthe
firstyearcouponisreinvestedataninterestrateofrpercent,thentotalproceedsatthe
endofthesecondyearwillbe:[$100(1+r)]+$1,100
Therefore,realizedcompoundyieldtomaturityisafunctionofr,asshowninthefollowing
table:
r

Totalproceeds

RealizedYTM=1

8%

$1,208

1=0.0991=9.91%

10%

$1,210

1=0.1000=10.00%
14-7

Chapter 14 - Bond Prices and Yields

12%

$1,212

1=0.1009=10.09%

14-8

Chapter 14 - Bond Prices and Yields

22.

April15ismidwaythroughthesemiannualcouponperiod.Therefore,theinvoiceprice
willbehigherthanthestatedaskpricebyanamountequaltoonehalfofthesemiannual
coupon.Theaskpriceis101.125percentofpar,sotheinvoicepriceis:
$1,011.25+($50)=$1,036.25

23.

FactorsthatmightmaketheABCdebtmoreattractivetoinvestors,thereforejustifyinga
lowercouponrateandyieldtomaturity,are:
i.
TheABCdebtisalargerissueandthereforemaysellwithgreaterliquidity.
ii. Anoptiontoextendthetermfrom10yearsto20yearsisfavorableifinterestrates
tenyearsfromnowarelowerthantodaysinterestrates.Incontrast,ifinterest
ratesincrease,theinvestorcanpresentthebondforpaymentandreinvestthe
moneyforahigherreturn.
iii. Intheeventoftrouble,theABCdebtisamoreseniorclaim.Ithasmore
underlyingsecurityintheformofafirstclaimagainstrealproperty.
iv. ThecallfeatureontheXYZbondsmakestheABCbondsrelativelymore
attractivesinceABCbondscannotbecalledfromtheinvestor.
v.
TheXYZbondhasasinkingfundrequiringXYZtoretirepartoftheissueeach
year.Sincemostsinkingfundsgivethefirmtheoptiontoretirethisamountatthe
lowerofparormarketvalue,thesinkingfundcanbedetrimentalforbondholders.

24.

a.

Thefloatingratenotepaysacouponthatadjuststomarketlevels.Therefore,it
willnotexperiencedramaticpricechangesasmarketyieldsfluctuate.Thefixed
ratenotewillthereforehaveagreaterpricerange.

b.

Floatingratenotesmaynotsellatparforanyofseveralreasons:
(i)TheyieldspreadbetweenoneyearTreasurybillsandothermoneymarket
instrumentsofcomparablematuritycouldbewider(ornarrower)thanwhenthe
bondwasissued.
(ii)Thecreditstandingofthefirmmayhaveeroded(orimproved)relativeto
Treasurysecurities,whichhavenocreditrisk.Therefore,the2%premiumwould
becomeinsufficienttosustaintheissueatpar.
(iii)Thecouponincreasesareimplementedwithalag,i.e.,onceeveryyear.
Duringaperiodofchanginginterestrates,eventhisbrieflagwillbereflectedin
thepriceofthesecurity.

c.

Theriskofcallislow.Becausethebondwillalmostsurelynotsellformuch
aboveparvalue(givenitsadjustablecouponrate),itisunlikelythatthebondwill
everbecalled.

14-9

Chapter 14 - Bond Prices and Yields

25.

26.

d.

Thefixedratenotecurrentlysellsatonly88%ofthecallprice,sothatyieldto
maturityisgreaterthanthecouponrate.Callriskiscurrentlylow,sinceyields
wouldneedtofallsubstantiallyforthefirmtouseitsoptiontocallthebond.

e.

The9%couponnotescurrentlyhavearemainingmaturityoffifteenyearsand
sellatayieldtomaturityof9.9%.Thisisthecouponratethatwouldbeneeded
foranewlyissuedfifteenyearmaturitybondtosellatpar.

f.

Becausethefloatingratenotepaysavariablestreamofinterestpaymentsto
maturity,theeffectivematurityforcomparativepurposeswithotherdebtsecurities
isclosertothenextcouponresetdatethanthefinalmaturitydate.Therefore,
yieldtomaturityisanindeterminablecalculationforafloatingratenote,with
yieldtorecoupondateamoremeaningfulmeasureofreturn.

a.

Theyieldtomaturityontheparbondequalsitscouponrate,8.75%.Allelse
equal,the4%couponbondwouldbemoreattractivebecauseitscouponrateisfar
belowcurrentmarketyields,anditspriceisfarbelowthecallprice.Therefore,if
yieldsfall,capitalgainsonthebondwillnotbelimitedbythecallprice.In
contrast,the8%couponbondcanincreaseinvaluetoatmost$1,050,offeringa
maximumpossiblegainofonly0.5%.Thedisadvantageofthe8%coupon
bond,intermsofvulnerabilitytobeingcalled,showsupinitshigherpromised
yieldtomaturity.

b.

Ifaninvestorexpectsyieldstofallsubstantially,the4%bondoffersagreater
expectedreturn.

c.

Implicitcallprotectionisofferedinthesensethatanylikelyfallinyields
wouldnotbenearlyenoughtomakethefirmconsidercallingthebond.In
thissense,thecallfeatureisalmostirrelevant.

a.

InitialpriceP0=$705.46[n=20;PMT=50;FV=1000;i=8]
Nextyear'spriceP1=$793.29[n=19;PMT=50;FV=1000;i=7]
HPR

b.

$50 ($793.29 $705.46)

0.1954 19.54%
$705.46

UsingOIDtaxrules,thecostbasisandimputedinterestundertheconstantyield
methodareobtainedbydiscountingbondpaymentsattheoriginal8%yield,and
simplyreducingmaturitybyoneyearatatime:
Constantyieldprices(comparethesetoactualpricestocomputecapitalgains):
P0=$705.46
P1=$711.89implicitinterestoverfirstyear=$6.43
14-10

Chapter 14 - Bond Prices and Yields

P2=$718.84implicitinterestoversecondyear=$6.95

14-11

Chapter 14 - Bond Prices and Yields

Taxonexplicitinterestplusimplicitinterestinfirstyear=
0.40($50+$6.43)=$22.57
Capitalgaininfirstyear=Actualpriceat7%YTMconstantyieldprice=
$793.29$711.89=$81.40
Taxoncapitalgain=0.30$81.40=$24.42
Totaltaxes=$22.57+$24.42=$46.99
$50 ($793.29 $705.46) $46.99
0.1288 12.88%
$705.46

c.

AftertaxHPR=

d.

Valueofbondaftertwoyears=$798.82[usingn=18;i=7%]
Reinvestedincomefromthetwocouponinterestpayments=
$501.03+$50=$101.50
Totalfundsaftertwoyears=$798.82+$101.50=$900.32
Therefore,theinvestmentof$705.46growsto$900.32intwoyears:
$705.46(1+r)2=$900.32r=0.1297=12.97%

e.

Couponinterestreceivedinfirstyear:
$50.00
Less:taxoncouponinterest@40%:
20.00
Less:taxonimputedinterest(0.40$6.43): 2.57
Netcashflowinfirstyear:
$27.43
Theyear1cashflowcanbeinvestedatanaftertaxrateof:
3%(10.40)=1.8%
Byyear2,thisinvestmentwillgrowto:$27.431.018=$27.92
Intwoyears,sellthebondfor:
$798.82
[n=18;i=7%]
Less:taxonimputedinterestinsecondyear:2.78 [0.40$6.95]
Add:aftertaxcouponinterestreceived
insecondyear:
+30.00
[$50(10.40)]
Less:Capitalgainstaxon
(salespriceconstantyieldvalue): 23.99
[0.30(798.82718.84)]
Add:CFfromfirstyear'scoupon(reinvested):+27.92 [fromabove]
Total
$829.97
$705.46(1+r)2=$829.97r=0.0847=8.47%

14-12

Chapter 14 - Bond Prices and Yields

CFAPROBLEMS
1.

a.

Asinkingfundprovisionrequirestheearlyredemptionofabondissue.The
provisionmaybeforaspecificnumberofbondsorapercentageofthebondissue
overaspecifiedtimeperiod.Thesinkingfundcanretirealloraportionofan
issueoverthelifeoftheissue.

b.

(i)Comparedtoabondwithoutasinkingfund,thesinkingfundreducesthe
averagelifeoftheoverallissuebecausesomeofthebondsareretiredpriortothe
statedmaturity.
(ii)Thecompanywillmakethesametotalprincipalpaymentsoverthelifeofthe
issue,althoughthetimingofthesepaymentswillbeaffected.Thetotalinterest
paymentsassociatedwiththeissuewillbereducedgiventheearlyredemptionof
principal.

2.

c.

Fromtheinvestorspointofview,thekeyreasonfordemandingasinkingfundis
toreducecreditrisk.Defaultriskisreducedbytheorderlyretirementoftheissue.

a.

(i)Currentyield=Coupon/Price=$70/$960=0.0729=7.29%
(ii)YTM=3.993%semiannuallyor7.986%annualbondequivalentyield.
Onafinancialcalculator,enter:n=10;PV=960;FV=1000;PMT=35
Computetheinterestrate.
(iii)Realizedcompoundyieldis4.166%(semiannually),or8.332%annualbond
equivalentyield.Toobtainthisvalue,firstfindthefuturevalue(FV)ofreinvested
couponsandprincipal.Therewillbesixpaymentsof$35each,reinvested
semiannuallyat3%perperiod.Onafinancialcalculator,enter:
PV=0;PMT=35;n=6;i=3%.Compute:FV=226.39
Threeyearsfromnow,thebondwillbesellingattheparvalueof$1,000because
theyieldtomaturityisforecasttoequalthecouponrate.Therefore,totalproceeds
inthreeyearswillbe:$226.39+$1,000=$1,226.39
Thenfindtherate(yrealized)thatmakestheFVofthepurchasepriceequalto
$1,226.39:
$960(1+yrealized)6=$1,226.39yrealized=4.166%(semiannual)

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Chapter 14 - Bond Prices and Yields

b.

Shortcomingsofeachmeasure:
(i)Currentyielddoesnotaccountforcapitalgainsorlossesonbondsboughtat
pricesotherthanparvalue.Italsodoesnotaccountforreinvestmentincomeon
couponpayments.
(ii)Yieldtomaturityassumesthebondishelduntilmaturityandthatallcoupon
incomecanbereinvestedatarateequaltotheyieldtomaturity.
(iii)Realizedcompoundyieldisaffectedbytheforecastofreinvestmentrates,
holdingperiod,andyieldofthebondattheendoftheinvestor'sholdingperiod.

3.

a.

Thematurityofeachbondistenyears,andweassumethatcouponsarepaid
semiannually.Sincebothbondsaresellingatparvalue,thecurrentyieldforeach
bondisequaltoitscouponrate.
Iftheyielddeclinesby1%to5%(2.5%semiannualyield),theSentinalbondwill
increaseinvalueto$107.79[n=20;i=2.5%;FV=100;PMT=3].
ThepriceoftheColinabondwillincrease,butonlytothecallpriceof102.The
presentvalueofscheduledpaymentsisgreaterthan102,butthecallpriceputsa
ceilingontheactualbondprice.

b.

Ifratesareexpectedtofall,theSentinalbondismoreattractive:sinceitisnot
subjecttocall,itspotentialcapitalgainsaregreater.
Ifratesareexpectedtorise,Colinaisarelativelybetterinvestment.Itshigher
coupon(whichpresumablyiscompensationtoinvestorsforthecallfeatureofthe
bond)willprovideahigherrateofreturnthantheSentinalbond.

c.

4.

Anincreaseinthevolatilityofrateswillincreasethevalueofthefirmsoptionto
callbacktheColinabond.Ifratesgodown,thefirmcancallthebond,whichputs
acaponpossiblecapitalgains.So,greatervolatilitymakestheoptiontocallback
thebondmorevaluabletotheissuer.Thismakesthebondlessattractivetothe
investor.

Marketconversionvalue=valueifconvertedintostock=20.83$28=$583.24
Conversionpremium=Bondpricemarketconversionvalue
=$775.00$583.24=$191.76

14-14

Chapter 14 - Bond Prices and Yields

5.

6.

a.

Thecallfeaturerequiresthefirmtoofferahighercoupon(orhigherpromised
yieldtomaturity)onthebondinordertocompensatetheinvestorforthefirm's
optiontocallbackthebondataspecifiedpriceifinterestratefallssufficiently.
Investorsarewillingtograntthisvaluableoptiontotheissuer,butonlyfora
pricethatreflectsthepossibilitythatthebondwillbecalled.Thatpriceisthe
higherpromisedyieldatwhichtheyarewillingtobuythebond.

b.

Thecallfeaturereducestheexpectedlifeofthebond.Ifinterestratesfall
substantiallysothatthelikelihoodofacallincreases,investorswilltreatthe
bondasifitwill"mature"andbepaidoffatthecalldate,notatthestated
maturitydate.Ontheotherhandifratesrise,thebondmustbepaidoffatthe
maturitydate,notlater.Thisasymmetrymeansthattheexpectedlifeofthe
bondislessthanthestatedmaturity.

c.

Theadvantageofacallablebondisthehighercoupon(andhigherpromisedyield
tomaturity)whenthebondisissued.Ifthebondisnevercalled,thenaninvestor
earnsahigherrealizedcompoundyieldonacallablebondissuedatparthananon
callablebondissuedatparonthesamedate.Thedisadvantageofthecallable
bondistheriskofcall.Ifratesfallandthebondiscalled,thentheinvestor
receivesthecallpriceandthenhastoreinvesttheproceedsatinterestratesthatare
lowerthantheyieldtomaturityatwhichthebondoriginallywasissued.Inthis
event,thefirm'ssavingsininterestpaymentsistheinvestor'sloss.

a.

(iii)

b.

(iii)Theyieldtomaturityonthecallablebondmustcompensatetheinvestorfor
theriskofcall.
Choice(i)iswrongbecause,althoughtheownerofacallablebondreceivesa
premiumplustheprincipalintheeventofacall,theinterestrateatwhichhecan
reinvestwillbelow.Thelowinterestratethatmakesitprofitablefortheissuerto
callthebondalsomakesitabaddealforthebondsholder.
Choice(ii)iswrongbecauseabondismoreapttobecalledwheninterestratesare
low.Onlyifratesarelowwilltherebeaninterestsavingfortheissuer.

c.

(iii)

d.

(ii)

14-15