Question1. A company is trying to find out if they should issue a 6% semi-annual coupon bond with 10 years till maturity or an 8% coupon semi-annual bond with 5 years till maturity. Comparable bonds are offering a yield-to-maturity of 7% right now however interest rates are expected to raise by 1% since the Federal Reserve expects 4% inflation and wants to slow the economy down so that inflation doesn’t get out of hand.
a. Given this info what will the real rate of return be when inflation does go up by 4%?
b. Given the info above tell me when the yield curve is likely to be upward sloping or downward sloping and why?
c. An investor with marginal tax rate of 25% is interested in buying one of these bonds yielding 7% or a municipal bond yielding 5%. Which kind of bond is most attractive to this investor?
d. What are initial prices of these bonds (e.g. before any coupons are paid)?
e. If these bonds are issued at price found in d) and interest rates immediately increase by 1% which bond demonstrates more interest rate risk? How can you tell?
f. Suppose the company decides to issue the 8% coupon bond. Exactly two years after it was issued you purchase this bond and hold onto it for 75 days. What price will you sell it for?
g. What does it mean if a firm’s bond rating is downgraded? What do you anticipates happening to the bond’s price and yield-to-maturity once this downgrade is announced?
h. Explain how the following provisions found in bond’s indenture can help protect the lender/bond purchaser?
i. Protective covenants
ii. Sinking Funds
iii. Secured Debt
iv. Senior Debt