Assume you have a one-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 8% coupon rate and pays the $80 coupon once per year. The third has a 10% coupon rate and pays the $100 coupon once per year.
a. If all three bonds are now priced to yield 8% to maturity, what are their prices?
b. If you expect their yields to maturity to be 8% 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 after-tax rate of return be on each?
c. Recalculate your answer to (b) under the same assumption that you expect the yields to maturity on each bond to be 7% at the beginning of next year?