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No. of Recommendations: 3
The Dutch auction of Zion Bankcorp's 5-year, 5%, triple-BBBs closes on 07/27. At the current, market-clearing 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 yield-curve below (where price includes a commish of a \$1 a bond and the YTMs are as E*Trade calculates them):
`Cpn	Due 	        Price	   YTM	5.000	11/07/12	103.861	   1.92%	5.650	05/15/14	104.100	   4.08%	7.750	09/23/14	109.950	   4.34%	6.000	09/15/15	104.100	   4.89%	5.500	11/16/15	103.600	   4.57%	5.500	11/16/15	101.615	   5.08%	5.500	05/10/16	101.972	   2.94%(YTC)	`

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 tax-rate on ordinary-income is 25% and on cap-gains, 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 net-effect is that buying the bond at 97 would result in an annual loss of purchasing-power of about 47 bps, aka, a tax-and-inflation-adjusted 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 bond-shopping can be done efficiently, 500 bonds at time, to find the very few that merit a further look.