Question Details

Assume you have a one-year investment horizon 



Question 1:
Consider a newly issued bond that pays its coupon once annually, and whose coupon rate is 5%;
the maturity is 20 years, and yield to maturity is 8%.
(a) Assuming there are no taxes, find the holding period return for a one-year investment period
if the bond is selling at a yield to maturity of 7% by the end of the year.
(b) (NOT EXAM MATERIAL) If you sell the bond after one year, what taxes will you owe if
the tax rate on interest income is 40% and the tax rate on capital gains income is 30%? The
bond is subject to original- issue discount tax treatment.
(c) (NOT EXAM MATERIAL) What is the after-tax holding period return on the bond?
Question 2:
Assume you have a one-year investment horizon and are trying to choose among three bonds.
All have the same degree of default risk and mature in 10 years. The first bond is a zero-coupon
bond that pays $1,000 at maturity. The second one has an 8% coupon rate and pays the $80
coupon once per year. The third bond has a 10% coupon rate and pays the $100 coupon once per
year. For parts (a) and (b), assume that there are no taxes.
(a) If all three bonds are now priced to yield 8% to maturity, what are their prices?
(b) If you expect their yields to maturity to be 8% at the beginning of next year, what will their
prices be then? What is your before-tax holding period return on each bond?
(c) (NOT EXAM MATERIAL) If your tax bracket is 30% on ordinary income and 20% on
capital gains income, what will your after-tax rate of return be on each bond?
Hint: In computing taxes, assume that the 10% coupon bond was issued at par and that the
drop in price, when the bond is sold at year-end, is treated as a capital loss (and not as
an offset to ordinary income).



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