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The credit standing of the firm may have eroded or

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The credit standing of the firm may have eroded (or improved) relative to Treasury securities, which have no credit risk. Therefore, the 2% premium would become insufficient to sustain the issue at par. The coupon increases are implemented with a lag, i.e., once every year. During a period of changing interest rates, even this brief lag will be reflected in the price of the security. c. The risk of call is low. Because the bond will almost surely not sell for much above par value (given its adjustable coupon rate), it is unlikely that the bond will ever be called. d. The fixed-rate note currently sells at only 88% of the call price, so that yield to maturity is greater than the coupon rate. Call risk is currently low, since yields would need to fall substantially for the firm to use its option to call the bond. e. The 9% coupon notes currently have a remaining maturity of fifteen years and sell at a yield to maturity of 9.9%. This is the coupon rate that would be needed for a newly-issued fifteen-year maturity bond to sell at par. f. Because the floating rate note pays a variable stream of interest payments to maturity, the effective maturity for comparative purposes with other debt securities is closer to the next coupon reset date than the final maturity date. Therefore, yield-to-maturity is an indeterminable calculation for a floating rate note, with “yield-to-recoupon date” a more meaningful measure of return. 27. a. The maturity of each bond is ten years, and we assume that coupons are paid semiannually. Since both bonds are selling at par value, the current yield for each bond is equal to its coupon rate. If the yield declines by 1% to 5% (2.5% semiannual yield), the Sentinal bond will increase in value to $107.79 [n=20; i = 2.5%; FV = 100; PMT = 3]. The price of the Colina bond will increase, but only to the call price of 102. The present value of scheduled payments is greater than 102, but the call price puts a ceiling on the actual bond price. 14-9
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b. If rates are expected to fall, the Sentinal bond is more attractive: since it is not subject to call, its potential capital gains are greater. If rates are expected to rise, Colina is a relatively better investment. Its higher coupon (which presumably is compensation to investors for the call feature of the bond) will provide a higher rate of return than the Sentinal bond. c. An increase in the volatility of rates will increase the value of the firm’s option to call back the Colina bond. If rates go down, the firm can call the bond, which puts a cap on possible capital gains. So, greater volatility makes the option to call back the bond more valuable to the issuer. This makes the bond less attractive to the investor. 28. a. The yield to maturity on the par bond equals its coupon rate, 8.75%. All else equal, the 4% coupon bond would be more attractive because its coupon rate is far below current market yields, and its price is far below the call price. Therefore, if yields fall, capital gains on the bond will not be limited by the call price. In contrast, the 8¾% coupon bond can increase in value to at most $1,050, offering a maximum possible gain of only 0.5%. The disadvantage of the 8¾% coupon bond, in terms of vulnerability to being called, shows up in its higher promised yield to maturity.
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