Answers to Concepts Review and Critical Thinking Questions 1. No. As interest rates fluctuate, the value of a Treasury security will fluctuate. Long-term Treasury securities have substantial interest rate risk. 2. All else the same, the Treasury security will have lower coupons because of its lower default risk, so it will have greater interest rate risk. 3. No. If the bid were higher than the ask, the implication would be that a dealer was willing to sell a bond and immediately buy it back at a higher price. How many such transactions would you like to do? 4. Prices and yields move in opposite directions. Since the bid price must be lower, the bid yield must be higher. 5. There are two benefits. First, the company can take advantage of interest rate declines by calling in an issue and replacing it with a lower coupon issue. Second, a company might wish to eliminate a covenant for some reason. Calling the issue does this. The cost to the company is a higher coupon. A put provision is desirable from an investor’s standpoint, so it helps the company by reducing the coupon rate on the bond. The cost to the company is that it may have to buy back the bond at an unattractive price. 6. Bond issuers look at outstanding bonds of similar maturity and risk. The yields on such bonds are used to establish the coupon rate necessary for a particular issue to initially sell for par value. Bond issuers also simply ask potential purchasers what coupon rate would be necessary to attract them. The coupon rate is fixed and simply determines what the bond’s coupon payments will be. The required return is what investors actually demand on the issue, and it will fluctuate through time. The coupon rate and required return are equal only if the bond sells for exactly par. 7. Yes. Some investors have obligations that are denominated in dollars; i.e., they are nominal. Their primary concern is that an investment provide the needed nominal dollar amounts. Pension funds, for example, often must plan for pension payments many years in the future. If those payments are fixed in dollar terms, then it is the nominal return on an investment that is important. 8. Companies pay to have their bonds rated simply because unrated bonds can be difficult to sell; many large investors are prohibited from investing in unrated issues. 9. Treasury bonds have no credit risk, so a rating is not necessary. Junk bonds often are not rated because there would no point in an issuer paying a rating agency to assign its bonds a low rating (it’s like paying someone to kick you!). 10. The term structure is based on pure discount bonds. The yield curve is based on coupon-bearing issues. 11. Bond ratings have a subjective factor to them. Split ratings reflect a difference of opinion among credit agencies. 12. As a general constitutional principle, the federal government cannot tax the states without their consent if doing so would interfere with state government functions. At one time, this principle was thought to provide for the tax-exempt status of municipal interest payments. However, modern courtrulings make it clear that Congress can revoke the municipal exemption, so the only basis now appears to be historical precedent. The fact that the states and the federal government do not tax each other’s securities is referred to as “reciprocal immunity.” 13. Lack of transparency means that a buyer or seller can’t see recent transactions, so it is much harder to determine what the best bid and ask prices are at any point in time. 14. One measure of liquidity is the bid-ask spread. Liquid instruments have relatively small spreads. Looking at Figure 6.4, the bellwether bond has a spread of one tick; it is one of the most liquid of all investments. Generally, liquidity declines after a bond is issued. Some older bonds, including some of the callable issues, have spreads as wide as six ticks. 15. Companies charge that bond rating agencies are pressuring them to pay for bond ratings. When a company pays for a rating, it has the opportunity to make its case for a particular rating. With an unsolicited rating, the company has no input. 16. A 100-year bond looks like a share of preferred stock. In particular, it is a loan with a life that almost certainly exceeds the life of the lender, assuming that the lender is an individual. With a junk bond, the credit risk can be so high that the borrower is almost certain to default, meaning that the creditors are very likely to end up as part owners of the business. In both cases, the “equity in disguise” has a significant tax advantage. Solutions to Questions and Problems Basic 1. The yield to maturity is the required rate of return on a bond expressed as a nominal annual interest rate. For noncallable bonds, the yield to maturity and required rate of return are interchangeable terms. Unlike YTM and required return, the coupon rate is not a return used as the interest rate in bond cash flow valuation, but is a fixed percentage of par over the life of the bond used to set the coupon payment amount. For the example given, the coupon rate on the bond is still 10 percent, and the YTM is 8 percent. 2. Price and yield move in opposite directions; if interest rates rise, the price of the bond will fall. This is because the fixed coupon payments determined by the fixed coupon rate are not as valuable when interest rates rise—hence, the price of the bond decreases. 3. P = $70(PVIFA8%,12) + $1000(PVIF8%,12) = $924.64 4. $896.50 = $100(PVIFAr%,8) + $1000(PVIFr%,8) ; r = YTM = 12.09% 5. $850 = $C(PVIFA8.2%,13) + $1000(PVIF8.2%,13); C = $62.81; coupon rate = 6.28% 6. P = $41.25(PVIFA4.6%,20) + $1000(PVIF4.6%,20) = $938.74 7. $870 = $42.00(PVIFAr%,20) + $1000(PVIFr%,20); r = 5.267%; YTM = 2 ×5.267 = 10.53% 8. $1,075 = $C(PVIFA4%,21) + $1000(PVIF4%,21); C = $45.35; coupon rate = 2 ×4.535 = 9.07% 9. Approximate = .06 –.035 =.025; Exact r = [(1 + .06) / (1 + 0.035)] – 1; r = 2.42%10. (1 + .035)(1 + .04) – 1 = 7.64% 11. (1 + .08)(1 + i) – 1 = 0.13; i = 4.63% 12. (1 + r)(1 + .06) – 1 = 0.14; r = 7.55% 13. This is a note. Coupon rate = 4.75%. Bid price = 89:29 = 89.90625%×$1,000 = $899.06 Previous day’s asked price = today’s asked price – change = 89 31/32 – 19/32 = 89 12/32 or 89:12= 89.375%× $1,000 = $893.75 14. This is a discount bond because it sells for less than 100% of face value. Current yield =