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CHAPTER5INTERESTRATESANDBONDVALUATIONAnswerstoConceptsReviewandCriticalThinkingQuestions1.No.Asinterestratesfluctuate,thevalueofaTreasurysecuritywillfluctuate.Long-termTreasurysecuritieshavesubstantialinterestraterisk.2.Allelsethesame,theTreasurysecuritywillhavelowercouponsbecauseofitslowerdefaultrisk,soitwillhavegreaterinterestraterisk.3.No.Ifthebidwerehigherthantheask,theimplicationwouldbethatadealerwaswillingtosellabondandimmediatelybuyitbackatahigherprice.Howmanysuchtransactionswouldyouliketodo?4.Pricesandyieldsmoveinoppositedirections.Sincethebidpricemustbelower,thebidyieldmustbehigher.5.Therearetwobenefits.First,thecompanycantakeadvantageofinterestratedeclinesbycallinginanissueandreplacingitwithalowercouponissue.Second,acompanymightwishtoeliminateacovenantforsomereason.Callingtheissuedoesthis.Thecosttothecompanyisahighercoupon.Aputprovisionisdesirablefromaninvestor’sstandpoint,soithelpsthecompanybyreducingthecouponrateonthebond.Thecosttothecompanyisthatitmayhavetobuybackthebondatanunattractiveprice.6.Bondissuerslookatoutstandingbondsofsimilarmaturityandrisk.Theyieldsonsuchbondsareusedtoestablishthecouponratenecessaryforaparticularissuetoinitiallysellforparvalue.Bondissuersalsosimplyaskpotentialpurchaserswhatcouponratewouldbenecessarytoattractthem.Thecouponrateisfixedandsimplydetermineswhatthebond’scouponpaymentswillbe.Therequiredreturniswhatinvestorsactuallydemandontheissue,anditwillfluctuatethroughtime.Thecouponrateandrequiredreturnareequalonlyifthebondsellsforexactlyatpar.7.Yes.Someinvestorshaveobligationsthataredenominatedindollars;i.e.,theyarenominal.Theirprimaryconcernisthataninvestmentprovidestheneedednominaldollaramounts.Pensionfunds,forexample,oftenmustplanforpensionpaymentsmanyyearsinthefuture.Ifthosepaymentsarefixedindollarterms,thenitisthenominalreturnonaninvestmentthatisimportant.8.Companiespaytohavetheirbondsratedsimplybecauseunratedbondscanbedifficulttosell;manylargeinvestorsareprohibitedfrominvestinginunratedissues.9.TreasurybondshavenocreditrisksinceitisbackedbytheU.S.government,soaratingisnotnecessary.Junkbondsoftenarenotratedbecausetherewouldbenopointinanissuerpayingaratingagencytoassignitsbondsalowrating(it’slikepayingsomeonetokickyou!).10.Thetermstructureisbasedonpurediscountbonds.Theyieldcurveisbasedoncoupon-bearingissues.11.Bondratingshaveasubjectivefactortothem.Splitratingsreflectadifferenceofopinionamongcreditagencies.12.Asageneralconstitutionalprinciple,thefederalgovernmentcannottaxthestateswithouttheirconsentifdoingsowouldinterferewithstategovernmentfunctions.Atonetime,thisprinciplewasthoughttoprovideforthetax-exemptstatusofmunicipalinterestpayments.However,moderncourtrulingsmakeitclearthatCongresscanrevokethemunicipalexemption,sotheonlybasisnowappearstobehistoricalprecedent.Thefactthatthestatesandthefederalgovernmentdonottaxeachother’ssecuritiesisreferredtoas“reciprocalimmunity.”13.Lackoftransparencymeansthatabuyerorsellercan’tseerecenttransactions,soitismuchhardertodeterminewhatthebestbidandaskpricesareatanypointintime.14.Onemeasureofliquidityisthebid-askspread.Liquidinstrumentshaverelativelysmallspreads.LookingatFigure7.4,thebellwetherbondhasaspreadofonetick;itisoneofthemostliquidofallinvestments.Generally,liquiditydeclinesafterabondisissued.Someolderbonds,includingsomeofthecallableissues,havespreadsaswideassixticks.15.Companieschargethatbondratingagenciesarepressuringthemtopayforbondratings.Whenacompanypaysforarating,ithastheopportunitytomakeitscaseforaparticularrating.Withanunsolicitedrating,thecompanyhasnoinput.16.A100-yearbondlookslikeashareofpreferredstock.Inparticular,itisaloanwithalifethatalmostcertainlyexceedsthelifeofthelender,assumingthatthelenderisanindividual.Withajunkbond,thecreditriskcanbesohighthattheborrowerisalmostcertaintodefault,meaningthatthecreditorsareverylikelytoendupaspartownersofthebusiness.Inbothcases,the“equityindisguise”hasasignificanttaxadvantage.17.a.Thebondpriceisthepresentvalueofthecashflowsfromabond.TheYTMistheinterestrateusedinvaluingthecashflowsfromabond.b.Ifthecouponrateishigherthantherequiredreturnonabond,thebondwillsellatapremium,sinceitprovidesperiodicincomeintheformofcouponpaymentsinexcessofthatrequiredbyinvestorsonothersimilarbonds.Ifthecouponrateislowerthantherequiredreturnonabond,thebondwillsellatadiscountsinceitprovidesinsufficientcouponpaymentscomparedtothatrequiredbyinvestorsonothersimilarbonds.Forpremiumbonds,thecouponrateexceedstheYTM;fordiscountbonds,theYTMexceedsthecouponrate,andforbondssellingatpar,theYTMisequaltothecouponrate.c.Currentyieldisdefinedastheannualcouponpaymentdividedbythecurrentbondprice.Forpremiumbonds,thecurrentyieldexceedstheYTM,fordiscountbondsthecurrentyieldislessthantheYTM,andforbondssellingatparvalue,thecurrentyieldisequaltotheYTM.Inallcases,thecurrentyieldplustheexpectedone-periodcapitalgainsyieldofthebondmustbeequaltotherequiredreturn.18.Along-termbondhasmoreinterestrateriskcomparedtoashort-termbond,allelsethesame.Alowcouponbondhasmoreinterestrateriskthanahighcouponbond,allelsethesame.Whencomparingah