Answers to Chapter 6
Questions:
1. Capital markets are markets that trade equity (stocks) and debt (notes, bonds, and mortgages) instruments with
maturities of more than one year. Bonds are long term debt obligations issued by corporations and government units.
Proceeds from a bond issue are used to raise funds to support long term operations of the issuer (e.g., for capital
expenditure projects). In return for the investor’s funds, bond issuers promise to pay a specified amount in the future
2. In contrast to T-bills which are sold on a discount basis from face value, T-notes and T-bonds pay coupon interest
3. A STRIP is a Treasury security in which periodic coupon interest payments can be separated from each other and
from the final principal payment. A STRIP effectively creates two securities–one for each interest payment and one
4. Like the fixed-coupon bonds issued by the Treasury, the coupon rate on TIPS is determined by the auction
process described below. However, unlike the fixed-principal bonds, the principal value of a TIPS bond can increase
However, the TIPS yield may be viewed as a real yield and the spread between the yields of TIPS and non-TIPS of
the same maturity is the market’s consensus estimate of average annual inflation over the period. While TIPS may
appear attractive to investors fearing inflation, the yields are lower. Further, the periodic principal adjustments are
5. Similar to primary market T-bill sales, the U.S. Treasury sells T-notes and T–bonds through competitive and
noncompetitive Treasury auctions (see Chapter 5). The Treasury issues a press release about a week before each
auction announcing the details of the auction, including the auction date, the amount to be sold, and other details
The auction is a single-price auction-all bidders pay the same price which is the price associated with the highest of
the competitive yields bid. At each auction, first noncompetitive bids are filled. Next, competitive bids are ranked
So far, the procedure described was the same as the one for T-bill auctions. The differences arise because notes and
bonds are coupon-bearing instruments. The coupon rate of the auctioned notes or bonds is the stop-out yield rounded
meaning that the price is usually slightly below par. This process helps ensure that successful bidders will not pay
more than the par value of the requested bonds. In Treasury auction result annoncements, the stop-out yield is called
6. General obligation (GO) bonds are backed by the full faith and credit of the issuer, i.e., the state or local
government promises to use all of its financial resources (e.g., its taxation powers) to repay the bond. GO bonds
have neither specific assets pledged as collateral backing the bond nor a specific revenue source identified as a
Revenue bonds are sold to finance a specific revenue generating project and are backed by cash flows from that
project. For example, a revenue bond may be issued to finance an extension of a state highway. To help pay off the
7. Bond insurance ensures payment to bondholders in the event that the issuer defaults on a payment. Generally, the
insurance company assuring a bond has a higher credit rating than the issuer. As a result, the bond issued will have
8. Public offerings of municipal bonds are most often made through an investment banking firm serving as the
underwriter. Normally, the investment bank facilitates this transfer using a firm commitment underwriting. The
investment bank guarantees the municipality (or corporation for a corporate bond) a price for newly issued bonds by
buying the whole issue at a fixed price from the municipal issuer (the bid price). The investment bank then seeks to
Some municipal (and corporate) securities are offered on a best efforts basis, in which the investment bank does not
guarantee a firm price to the issuer (as with a firm commitment offering) and acts more as a placing or distribution
agent for a fee. With best-efforts offerings, the investment bank incurs no risk of mispricing the security since it
9. The bond indenture is the legal contract that specifies the rights and obligations of the bond issuer and the bond
holders. The bond indenture contains a number of covenants associated with a bond issue. These bond covenants
describe rules and restrictions placed on the bond issuer and bond holders. These covenants include such rights for
the bond issuer as the ability to call the bond issue and restrictions as to limits on the ability of the issuer to increase
made from the bond issuer to the bond holder. The trustee also informs the bond holders if the firm is no longer
10. With bearer bonds, coupons are attached to the bond and the holder (bearer) at the time of the coupon payment
gets the relevant coupon paid on presentation to the issuer. With a registered bond, the bondholder (or owner) is kept
11. Most corporate bonds are term bonds meaning that the entire issue matures on a single date. Some corporate
bonds and most municipals bonds, on the other hand, are serial bonds, meaning that the issue contains many
12. a. subordinated debenture
13. Convertible bonds are bonds that may be exchanged for another security of the issuing firm (e.g., common
stock) at the discretion of the bondholder. If the market value of the securities the bondholder receives with
14. A call provision allows the issuer to require the bondholder to sell the bond back to the issuer at a given (call)
price–usually set above the par value of the bond. The difference between the call price and the face value on the
bond is the call premium. Bonds are usually called in when interest rates drop (and bond prices rise) so that the
15. A sinking fund provision which is a requirement that the issuer retire a certain amount of the bond issue early
over a number of years, especially as the bond approaches maturity. The bond issuer provides the funds to the trustee
16. Bonds rated Baa or better by Moody’s and BBB or better by S&P are considered to be investment grade bonds.
Financial institutions are generally prohibited by state and federal law from purchasing anything but investment
17. The present values of the cash flows on bonds decreases as the required rate of return increases. This is the
inverse relationship between present values and interest rates we discussed in Chapter 2. While the examples in the
chapter refer to the relation between fair present values and required rates of returns, the inverse relation also exists
between current market prices and expected rates of return—as yields on bonds increase, the current market prices
18. All else equal, a long-term bond experiences larger price changes when interest rates change than a short-term
19. Rating agencies consider several factors in determining and assigning credit ratings on bond issues. For
example, a financial analysis is conducted of the issuer’s operations and its needs, its position in the industry, and its
overall financial strength and ability to pay the required interest and principal on the bonds. Rating agencies analyze
In recent years rating agencies have been criticized as slow to react. One example of this was the failure of rating
agencies to downgrade ratings on mortgage-backed securities. Throughout the financial crisis, major credit rating
firms were criticized for putting top ratings on these securities, which ultimately collapsed in value and led to
billions of dollars of losses for investors who had relied on the ratings to signal which securities were safe to buy.
Further, because rating agencies, in particular Moody’s, Standard & Poor’s, and Fitch, are for-profit companies, their
incentives were criticized for being misaligned. Specifically, conflicts of interest arose because the rating agencies
20. In Chapter 2, we examined factors that affect interest rates on individual bonds. These factors included default
risk, liquidity risk, special provisions written into the bond contract (e.g., callability, sinking fund provisions), and
the term to maturity of the bond. In addition to these factors that are unique to each bond, interest rates on all bonds
are affected by inflation and the real risk free rate (typically measured using Treasury rates). The interest rate spread
on a bond contains information on how these other factors along with default risk affect the yield on a bond. The
21. Bond markets bring together suppliers and demanders of long-term funds. The major issuers of debt market
securities are federal, state, and local governments and corporations. The major purchasers of capital market
securities are households, businesses, government units, and foreign investors. Figure 6–11 shows the percentage of
each type of bond security held by the major groups. Notice in Figure 6–11 that financial firms, called Business
22. Eurobonds are long term bonds issued and sold outside the country of the currency in which they are
denominated (e.g., dollar denominated bonds issued in Europe or Asia). Foreign bonds are long term bonds issued
23. Sovereign bonds are government issued debt. Sovereign bonds have historically been issued in foreign
currencies, either U.S. dollars or euros. Lesser developed country (LDC) sovereign debt tends to have lower credit
ratings than other sovereign debt because of the increased economic and political risks. Where most developed
countries are either AAA or AA-rated, most LDC issuance is rated below investment grade, though a few countries
that have seen significant improvements have been upgraded to BBB or A ratings, and a handful of lower income
24. In July 2001, Argentinian sovereign bonds were trading at spreads of over 15 percent above U.S. Treasury rates,
with the J.P. Morgan Emerging Market Bond Index showing a spread of nearly 10 percent over U.S. Treasuries. This
reflected the serious economic problems in Argentina and the contagious effects these were having on other
sovereign bond markets. More recently, in September 2008, fears of the global economic crisis and falling
Problems with sovereign bonds continued into 2009 and 2010. For example, in November 2009, Dubai World, the
finance arm of Dubai, asked creditors for a six month delay on interest payments due on $60 billion of the country’s
debt. In the mid- and late 2000s, Dubai became a center of investment and development, much of it funded by
burgeoning oil wealth from neighboring countries. But during the financial crisis, the Middle East nation was hard
The problems in the Greek bond market then spread to other European nations with fiscal problems, such as
Portugal, Spain, and Italy. As a result, in May euro-zone countries and the International Monetary Fund, seeking to
halt a widening European debt crisis that had now threatened the stability of the euro, agreed to extend Greece an
unprecedented $147 billion rescue in return for huge budget cuts. Additional rescue packages and promises of
At one point, Greece seemed unable to form a government and the leader of one party rejected the country’s bailout
commitments. It seemed increasingly conceivable that Greece might have to leave the euro zone. Economists’
estimated that a Greek exit from the Eurozone would cost the European Union $1 trillion, or about 5 percent of the
Union’s annual economic output. Yet, the leaders of EU countries, particularly Germany and France, continued to
work to keep Greek reform on track and the EU together. Further, the ECB stated that it would do whatever it took
Under the doctrine of sovereign-immunity, the repayment of sovereign debt cannot be forced by the creditors and it
is thus subject to compulsory rescheduling, interest rate reduction, or even repudiation. The only protection available
Problems:
1. a. The Ask price is $10,000 x 84.8516% = $8,485.160
2. a. July 18, 2013 to August 31, 2014 is 1 year 43 days, or 1.11780822 years. Thus,
b. July 18, 2013 to May 31, 2014 is 316 days, or 0.86575342 years. Thus,
3. a. July 18, 2013 to August 15, 2016 is 3.07945205 years. Also, the Asked price is 97.888%. Thus,
b. July 18, 2013 to November 15, 2027 is 14.33424658 years. Thus,
4. a. Accrued interest over the 145 days is calculated as:
of the face value of the bond, or $172.38 per $10,000 face value bond.
b. Clean price + Accrued interest = Dirty price
of the face value of the bond, or $10,697.3845 per $10,000 face value bond.
5. a. Accrued interest over the 12 days is calculated as:
of the face value of the bond, or $6.92935 per $10,000 face value bond.
b. Clean price + Accrued interest = Dirty price
of the face value of the bond, or $9,831.92935 per $10,000 face value bond.
6. a. The inflation-adjusted principal at the end of the first six months June 30, 2016, is found by multiplying the
original par value ($100,000) by the semiannual inflation rate. Thus, the principal amount is adjusted upward by
b. The inflation adjusted principal at the beginning of the second six months is $100,300.
c. The principal amount used to determine the second coupon payment is adjusted upward by 1 percent (e.g.,
7. a. The inflation-adjusted principal at the end of the first six months June 30, 2017, is found by multiplying the
b. The inflation adjusted principal at the beginning of the second six months is $102,500.
c. The principal amount used to determine the second coupon payment is adjusted upward by 0.5 percent (e.g.,
b. If your marginal tax rate is 21 percent, the after-tax or equivalent tax exempt yield on the taxable bond is
6.75%/(1 – .21) = 8.554%
11. July 18, 2013 to October 1, 2044 is 9 years 75 days, or 9.20547945 years. Thus,
13. a. The closing price of Goldman Sachs 2.375% bonds on July 16, 2013 was 98.878% of the face value of the
bond.
14. July 18, 2013 to June 1, 2017 is 3 years 317 days, or 3.86849315 years. Thus,
15. Before the rating change:
After the rating change:
16. Since the client’s marginal tax rate is 33 percent, the tax equivalent yield on the municipal bond is 4.5%/(1 – 0.33) =
17. Before the rating change:
After the rating change:
18. EXCEL Problem: Bond value = 102-17%
19. a. If a bond holder were to convert Hilton Hotels bonds into stock, each bond (worth $975.00) could be
b. The bonds are currently worth $975.00 per bond, while their conversion value is $974.5. Thus, there is
20. a. If a bond holder were to convert Gentherm bonds into stock, each bond (worth $1,025.00) could be
b. The bonds are currently worth $1,025.00 per bond, while their conversion value is $898.2125. Thus, the