Assume you have a 1-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 is a zero-coupon bond that pays $1,000 at maturity. The second has an 7.0% coupon rate and pays the $70 coupon once per year. The third has a 8.0% coupon rate and pays the $80 coupon once per year.
a. If all three bonds are now priced to yield 6% to maturity, what are their prices?
b. If you expect their yields to maturity to be 6% at the beginning of next year, what will their prices be then? What is your before-tax holding-period return on each bond? If your tax bracket is 30% on ordinary income and 20% on capital gains income, what will your aftertax rate of return be on each?
c. If you expect their yields to maturity to be 5% at the beginning of next year, what will their prices be then? What is your before-tax holding-period return on each bond? If your tax bracket is 30% on ordinary income and 20% on capital gains income, what will your aftertax rate of return be on each?