Question

Smith Industries issued $10,000,000 of corporate bonds with a 30-year maturity five years ago. The bonds have a coupon rate of 10.125 percent, paying interest semiannually, and have a par value of $1,000 per bond. The bonds are currently trading at a price of $879.625 per bond. A 25-year Treasury bond with a 6.825 percent coupon rate (paid semiannually) and $1,000 par is currently selling for $975.42. Determine the yield spread between the corporate bond and the Treasury bond. If you are considering investing in Smith’s bonds and you have an 11 percent required rate of return, would you purchase them, assuming you plan to hold them to maturity? Why or why not?

Answer 1

The yield spread between the corporate bond and the Treasury bond is 11.25%. If the investor's required rate of return is 11%, they may consider purchasing the Smith Industries bonds.

Step-by-step explanation:

The yield spread between the corporate bond and the Treasury bond can be determined by subtracting the yield of the Treasury bond from the yield of the corporate bond. In this case, the yield on the corporate bond is (1000 - 879.625)/879.625 = 0.1378 or 13.78% and the yield on the Treasury bond is (1000 - 975.42)/975.42 = 0.0253 or 2.53%. Therefore, the yield spread is 13.78% - 2.53% = 11.25%.

Next, to determine whether to purchase the Smith Industries bonds, we need to compare the required rate of return (11%) with the yield on the corporate bond (13.78%). Since the yield on the corporate bond is higher than the required rate of return, it indicates that the bond is offering a higher return than the investor's required rate. Therefore, the investor may consider purchasing the Smith Industries bonds.