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Subject: Discounting YTMs  Date: 7/22/2011 4:20 PM  
Author: charliebonds  Number: 33115 of 37023  
The Dutch auction of Zion Bankcorp's 5year, 5%, tripleBBBs closes on 07/27. At the current, marketclearing price of 97.000, the bond would offer a nominal 5.70% to maturity. Is this a good deal? On the surface, it would seem to be, given their current yieldcurve below (where price includes a commish of a $1 a bond and the YTMs are as E*Trade calculates them):
However, taxes have to be paid on gains, and inflation will erode returns. So let’s run the numbers. Excel’s YIELD formula asks for the following facts: Settlement, Maturity, Coupon_Rate, Purchase_Price Remption_ Price, Coupon_Frequency, and (optionally) Year_Type, as below: 07/27/11 08/01/16 .05 97 100 2 1 If one’s marginal taxrate on ordinaryincome is 25% and on capgains, 15%, then the coupon degrades to .035 and the redemption to 97.450. When those numbers are used in the formula, the YTM becomes 3.69%. But the situation is worse. If inflation is assumed to be 5%, then the coupon is further degraded and becomes .031 and the redemption degrades to 78.297. The neteffect is that buying the bond at 97 would result in an annual loss of purchasingpower of about 47 bps, aka, a taxandinflationadjusted YTM of (0.47%) That’s tolerable, but it probably wasn’t what was intended, nor what will be achieved, because it is probable that the bond will be sold at a higher price than the current bid. Some fussing in Excel suggests that a price of 94.935 would put a buyer even, and anything less would begin to appreciate capital. Why run these kinds of exercises? So that one's bondshopping can be done efficiently, 500 bonds at time, to find the very few that merit a further look. 

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