Ms. Alumm is the portfolio manager for a large insurance company. She is considering investing $1 million to purchase the bonds of Patriot Enterprises, Inc.
[A] All of Patriot's bonds have market prices that imply a yield to maturity of 8% "bond equivalent yield" (that is, 4% every 6-month period).1 Each Patriot bond is described here, based on a $1,000 face value (par value), which is the promised payment at maturity.
. Bond A has five years until maturity and pays a 9% coupon yield ($45 every 6 months on a $1,000 face value bond).
. Bond B has ten years until maturity, pays an 8% coupon yield ($40 semiannual payments), and is being offered in a private placement at par.
. Bond C is a zero-coupon bond that pays no explicit interest, but will pay the face amount of $1,000 per bond at maturity in ten years.
1. At what price should each bond sell currently?
[B] Ms. Alumm realizes that in addition to determining the current prices of these bonds, she would also like to know how these prices might respond to changing interest rates once her company has purchased them.
2. After purchasing the bonds at an 8% bond-equivalent yield, what would happen to the price of each bond, and how much money would the company make if market yields on Patriot bonds fall to 6%?. . . rise to 10%?
[C] As an alternative, Ms. Alumm has been invited to invest $1 million in a private placement of a 10-year Eurobond2 of a second firm, Nationaliste, S.A. Nationaliste bonds are similar in risk to "Bond B" above: they promise an 8% coupon yield for 10 years, but coupons are paid annually, not semiannually. The Nationaliste bonds are priced at a 1% discount from par, or $990 per $1,000 face value.
3. What yield to maturity is implied by the Nationaliste Eurobond? Compare this yield to the 8% "bondequivalent yield" of the Patriot semiannual coupon bond (Bond B) above. What should Ms. Alumm do?