LOS b, (Part 1): Describe the basic features of a bond.

Payments for U.S. Treasury bonds and notes are semiannual and are fixed for the life of each bond or note. The coupon rate is quoted on an annual basis but each payment is made on the basis of one half the annual rate multiplied by the maturity or par value.

 

The dollar amount of the coupon payment is computed as follows:

Coupon in $ = $5,000 × 0.085 / 2 = $212.50

A floor sets a minimum coupon rate for a floating-rate bond and protects the security owner from decreases in rates. A prepayment option is included in many amortizing securities and allows the holder of the option to make additional payments against outstanding principal.

Bonds issued by governments are likely to be denominated in the currency of the country where the bond is issued. In this case, the Euro is the Italian currency and bonds issued by the Italian government would normally be issued in Euros.

Each of the remaining cash flows on the bond is discounted at the annual rate of 4.5%.

Period	Payment	Discount	PV
1	$1,000 × 7% = $70	(1.045)1	$ 66.99
2	$1,000 × 7% = $70	(1.045)2	$ 64.10
3	$1,000 × 7% = $70	(1.045)3	$ 61.34
3	$1,000 principal	(1.045)3	$ 876.30
Total Present Value of Cash Flows			$1,068.73

The present value can also be determined with a financial calculator. N = 3, I = 4.5%, PMT = $1,000 × 7%, FV = $1,000. Solve for PV = $1,068.724.

LOS b, (Part 2): Describe the various coupon rate structures.

Zero-coupon bonds are quite special. Because zero-coupon bonds have no coupons (all of the bond’s return comes from price appreciation), investors have no uncertainty about the rate at which coupons will be invested. Spot rates are defined as interest rates used to discount a single cash flow to be received in the future. Any bond can be viewed as the sum of the present value of its individual cash flows where each of those cash flows are discounted at the appropriate zero-coupon bond spot rate.

 

The graph of yields on zero-coupon bonds (spot rates) is called the spot yield curve. Note that the return on zero-coupon bonds is based entirely on price appreciation. An investor in a default-free zero-coupon bond will not have to worry about reinvesting coupons to realize the yield to maturity.

Zero-coupon bonds are quite special. Because zero-coupon bonds have no coupons (all of the bond’s return comes from price appreciation), investors have no uncertainty about the rate at which coupons will be invested. Spot rates are defined as interest rates used to discount a single cash flow to be received in the future. If the yield to maturity on a 2-year zero is 6%, we can say that the 2-year spot rate is 6%.

Zero-coupon bonds are quite special. Because zero-coupon bonds have no coupons (all of the bond’s return comes from price appreciation), investors have no uncertainty about the rate at which coupons will be invested. An investor who holds a zero-coupon bond until maturity will receive a return equal to the bond’s effective annual yield.

This choice accurately describes a coupon bond.

With an accrual bond, payments are deferred to maturity and then disbursed along with the par value at maturity. Unlike a normal zero-coupon bond, these issues are sold at (or near) their par values and then the interest accrues at a compound rate on top of that. So, they start at $1,000 and then appreciate from there.

Zero coupon bonds always sell below their par value, or at a discount prior to maturity. The amount of the discount may change as interest rates change, but a zero coupon bond will always be priced less than par.

Accrual bonds, unlike zero-coupon bonds, do not always sell at a discount to face value. The interest accrues forward and thus the bonds are likely to sell for more than face value.

LOS b, (Part 3): Describe the structure of floating-rate securities.

Consider a floating rate issue that has a coupon rate that is reset on January 1 of each year. The coupon rate is defined as one-year London Interbank Offered Rate (LIBOR) + 125 basis points and the coupons are paid semi-annually. If the one-year LIBOR is 6.5% on January 1, which of the following is the semi-annual coupon payment received by the holder of the issue in that year?

A) 3.875%.

B) 3.250%.

C) 7.750%.

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A cap limits the upside potential of the coupon rate paid on the floating rate bond and is therefore a disadvantage to the bondholder. A floor limits the downside potential of the coupon rate and is therefore a disadvantage to the bond issuer.

The coupon rate is set in the bond agreement (indenture) and cannot be changed unilaterally. Non-interest rate indexed floaters are indexed to a commodity price such as oil or aluminum. Business results could be impacted by numerous factors other than aluminum prices.

Both of the other choices are true. By linking the coupon payments directly to the price of aluminum (meaning that when aluminum prices increase, the coupon rate increases and vice versa), the non-interest index floater allows Allcans to protect its credit rating during adverse circumstances.