1) A company is trying to determine if they should issue a 6% semi-annual coupon bond with 10 years until maturity or an 8% coupon semi-annual bond with 5 years until maturity. Comparable bonds are offering a yield-to-maturity of 7% right now but interest rates are expected to increase by 1% since the Federal Reserve anticipates 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 if inflation does go up by 4%?
b. Given the info above tell me if the yield curve is likely to be upward sloping or downward sloping and why?
c. An investor with a marginal tax rate of 25% is interested in buying one of these bonds yielding 7% or a municipal bond yielding 5%. Which type of bond is most attractive to this investor?
d. What are the initial prices of these bonds (e.g. before any coupons are paid)?
e. If these bonds are issued at the price found in d) and interest rates immediately rise by 1% which bond exhibits more interest rate risk? How can you tell?
f. Assume the company decides to issue the 8% coupon bond. Exactly two years after it was issued you buy 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 expect to happen to the bond's price and yield-to-maturity once this downgrade is announced?
h. Explain how the following provisions found in the bond's indenture can help protect the lender/bond purchaser?
i. Sinking Funds
ii. Protective covenants
iii. Senior Debt
iv. Secured Debt