Assignment:
Assume you have a one-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 bond is a zero-coupon bond that pays $1,000 at maturity. The second one has an 8% coupon rate and pays the $80 coupon once per year. The third bond has a 10% coupon rate and pays the $100 coupon once per year. For parts (a) and (b), assume that there are no taxes.
(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 bond?
Hint: In computing taxes, assume that the 10% coupon bond was issued at par and that the drop in price, when the bond is sold at year-end, is treated as a capital loss (and not as an offset to ordinary income).