Mini cases
Sam Strother and Shawna Tibbs are vice presidents of Mutual of Seattle Insurance Company and codirectors of the company's pension fund management division. An important new client, the North-Western Municipal Alliance, has requested that Mutual of Seattle present an investment seminar to the mayors of the represented cities, and Strother and Tibbs, who will make the actual presentation, have asked you to help them by answering the following questions. Because the Boeing Company operates in one of the league's cities, you are to work Boeing into the presentation.
a. What are the key features of a bond?
b. What are call provisions and sinking fund provisions? Do these provisions make bonds more or less risky?
c. How is the value of any asset whose value is based on expected future cash flows determined? d. How is the value of a bond determined? What is the value of a 10-year, $1,000 par value bond with a 10 percent annual coupon if its required rate of return is 10 percent?
e. (1) What would be the value of the bond described in part d if, just after it had been issued, the expected inflation rate rose by 3 percentage points, causing investors to require a 13 percent return? Would we now have a discount or a premium bond?
(2) What would happen to the bond's value if inflation fell, and rd declined to 7 percent? Would we now have a premium or a discount bond?
(3) What would happen to the value of the 10- year bond over time if the required rate of return remained at 13 percent, or if it remained at 7 percent? [Hint: With a financial calculator, enter PMT, I, FV, and N, and then change (override) N to see what happens to the PV as the bond approaches maturity.]
f. (1) What is the yield to maturity on a 10-year, 9 percent, annual coupon, $1,000 par value bond that sells for $887.00? That sells for $1,134.20? What does the fact that a bond sells at a discount or at a premium tell you about the relationship between rd and the bond's coupon rate?
(2) What are the total return, the current yield, and the capital gains yield for the discount bond? (Assume the bond is held to maturity and the company does not default on the bond.)
g. What is interest rate (or price) risk? Which bond has more interest rate risk, an annual payment 1-year bond or a 10-year bond? Why?
h. What is reinvestment rate risk? Which has more reinvestment rate risk, a 1-year bond or a 10- year bond?
i. How does the equation for valuing a bond change if semiannual payments are made? Find the value of a 10-year, semiannual payment, 10 percent coupon bond if nominal rd = 13%.
j. Suppose you could buy, for $1,000, either a 10 percent, 10-year, annual payment bond or a 10 percent, 10-year, semiannual payment bond. They are equally risky. Which would you prefer? If $1,000 is the proper price for the semiannual bond, what is the equilibrium price for the annual payment bond?
k. Suppose a 10-year, 10 percent, semiannual coupon bond with a par value of $1,000 is currently selling for $1,135.90, producing a nominal yield to maturity of 8 percent. However, the bond can be called after 5 years for a price of $1,050.
(1) What is the bond's nominal yield to call (YTC)?
(2) If you bought this bond, do you think you would be more likely to earn the YTM or the YTC? Why?
l. Boeing's bonds were issued with a yield to maturity of 7.5 percent. Does the yield to maturity represent the promised or expected return on the bond?
m. Boeing's bonds were rated AA by S&P. Would you consider these bonds investment grade or junk bonds?
n. What factors determine a company's bond rating?
o. If this firm were to default on the bonds, would the company be immediately liquidated? Would the bondholders be assured of receiving all of their promised payments?