Assume you have a 1-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 is a zero-coupon bond that pays $1,000 at maturity. The second has an 8% coupon rate and pays the $80 coupon once per year. The third has a 10% coupon rate and pays the $100 coupon once per year.
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) 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?
d) Recalculate your answer to (b) under the assumption that you expect the yields to maturity ?on each bond to be 7% at the beginning of next year.