Question

Bond yields (LO16-2) An investor must choose between two bonds:

Bond A pays $72 annual interest and has a market value of $925. It has 10 years to maturity. Bond B pays $62 annual interest and has a market value of $910. It has two years to maturity. Assume the par value of the bonds is $1,000.

a. Compute the current yield on both bonds.

b. Which bond should she select based on your answer to part a?

c. A drawback of current yield is that it does not consider the total life of the bond. For example, the yield to maturity on Bond A is 8.33 percent. What is the yield to maturity on Bond B?

d. Has your answer changed between parts b and c of this question in terms of which bond to select?

Answer 1

a

current yield = coupon rate*par value/current price

Current yield%=(7.2/100)*1000/925

Current yield% = 7.78

current yield = coupon rate*par value/current price

Current yield%=(6.2/100)*1000/910

Current yield% = 6.81

b

Choose A as it has higher current yield

c

K = N

Bond Price =∑ [(Annual Coupon)/(1 + YTM)^k]     +   Par value/(1 + YTM)^N

k=1

K =10

925 =∑ [(7.2*1000/100)/(1 + YTM/100)^k]     +   1000/(1 + YTM/100)^10

k=1

YTM% = 8.33

K = N

Bond Price =∑ [(Annual Coupon)/(1 + YTM)^k]     +   Par value/(1 + YTM)^N

k=1

K =2

910 =∑ [(6.2*1000/100)/(1 + YTM/100)^k]     +   1000/(1 + YTM/100)^2

k=1

YTM% = 11.49

d

Choose Bond B as it has higher YTM, answer has changed