Fixed Income【Reading 56】Sample discount, without, interest, 2012

Gypsy

If the Federal Reserve wishes to lower market interest rates without changing the discount rate, it can:

A) buy Treasury securities.

B) raise the yield on Treasury securities.

C) increase bank reserve requirements.

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Buying Treasury securities pumps money into the economy, lowering interest rates. Higher reserve requirements will restrict the money supply, causing rates to rise. The Federal Reserve has no direct control over the yield on existing Treasury securities.

hinsafdar

A funded investor has a short-term investment returning a 7% return. The borrowing costs are 20 basis points above the reference rate. If the T-bill rate is 3% and the LIBOR rate is 3.5%, what is the investor’s current profit on this investment?

A) 3.8%.

B) 1.5%.

C) 3.3%.

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A funded investor is one who borrows to invest. These investors typically borrow short-term and the interest rate on their loan is typically short-term LIBOR plus a margin, here LIBOR plus 20 basis points. Thus in this example, the investor’s cost of funds is 3.7%. His profit is then 7% − 3.7% = 3.3%.

hinsafdar

The most important LIBOR rate for funded investors is the:

A) 1 year or less rate.

B) 20 year rate.

C) 10 year rate.

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A funded investor is one who borrows to invest. These investors typically borrow short-term and the interest rate on their loan is typically short-term LIBOR plus a margin (e.g. LIBOR plus 30 basis points).

hinsafdar

The interest rate paid on negotiable CDs by banks in London is referred to as:

A) LIBOR.

B) the Fed Funds rate.

C) the London rate.

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The interest rate paid on negotiable CDs by banks in London is referred to as LIBOR. LIBOR is determined every day by the British Bankers Association. The Fed Funds rate is the rate paid on interbank loans within the U.S. The London rate is a fabricated term in this context.

hinsafdar

What would the marginal tax rate have to be for an investor to be indifferent between a 6% yield on tax exempt municipal bonds and a 10% corporate bond?

A) 60%.

B) 20%.

C) 40%.

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10 = 6 / (1 − MTR )
0.10 = 0.06 / (1 – MTR); 0.10 – 0.1MTR = 0.06;
MTR = -0.04 / -0.10 = 0.40 or 40%

hinsafdar

A municipal bond selling at 12% above par offers a yield of 3.2%. A taxable Treasury note selling at an 8% discount offers a yield of 4.6%. An investor in the 32.5% tax bracket wishes to purchase an equal dollar amount of both bonds. The after-tax yield of the two-bond portfolio is closest to:

A) 4.67%.

B) 2.63%.

C) 3.15%.

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The after-tax yield of the Treasury note is the stated yield times one minus the tax rate, or 4.6% times 67.5%, or 3.1%. To calculate the portfolio yield, take the average after-tax yields of both bonds, which is 3.15%.

hinsafdar

A municipal bond carries a coupon of 6% and is traded at par. To a taxpayer in the 34% tax bracket, this bond provides an equivalent taxable yield of:

A) 9.09%.

B) 8.53%.

C) 6.00%.

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ETY = yield/(1 − marginal tax rate)
0.06/(1 − 0.34) = 9.09%

Gypsy

A 6% annual coupon paying bond has two years remaining to maturity and is priced at par. Assuming a 40% tax rate, the after-tax yield for this bond is closest to:

A) 4.8%.

B) 3.6%.

C) 2.4%.

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Since the bond is trading at par, its yield to maturity is equal to its coupon rate of 6.0%. The after-tax yield is (1 − 0.4)(6.0%) = 3.6%.

Gypsy

A municipal bond carries a coupon of 6.75% and is traded at par. To a taxpayer in the 28% tax bracket, this bond provides an equivalent taxable yield of:

A) 6.75%.

B) 8.53%.

C) 9.38%.

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ETY = Yield/(1 − Marginal Tax Rate)
0.0675/(1 − 0.28) = 9.38%

Gypsy

Consider three corporate bonds that are identical in all respects except as noted:

• Bond F has $100 million face value outstanding. On average, 200 bonds trade per day.
• Bond G has $300 million face value outstanding. On average, 200 bonds trade per day.
• Bond H has $100 million face value outstanding. On average, 500 bonds trade per day.

Will the yield spreads to Treasuries of Bond G and Bond H be higher or lower than the yield spread to Treasuries of Bond F?

A) Higher for both.

B) Higher for one only.

C) Lower for both.

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Liquidity is attractive to investors, so they will pay a higher price (demand a lower yield) for a more liquid bond than for an identical bond that is less liquid. Bond G is more liquid than Bond F because of its greater size. Bond H is more liquid than Bond F because it trades in greater volume. Therefore both Bond G and Bond H will tend to have lower yield spreads to Treasuries than Bond F.