Question

Suppose you decide to invest in corporate bonds. Accordingly, you visit a bond store. You see 3 bonds on the shelf. One is priced at $1,015.53, another is priced to sell at $1,300.00, and a third is selling at a discounted amount of $876.06. All have a $1,000.00 face value, and carry equal risk. From your reading, and from class lecture, you know that you will be earning the same rate on your investment, regardless of which bond(s) you purchase. But you have a friend with you, who doesn't understand how you can possibly earn the same interest rate, due to the difference in purchase price. How will you explain this concept to him or her?

Answer 1

If the bond is of similar risk, then the require rate of the yield to maturity on the bonds are similar and if the price difference occurs then that difference is mainly due to the coupon payment or non-coupon payment. The important here to note is that bond can be premium bonds, discount bond or par value bond. When the coupon rate is 0, it is also called a zero coupon bond and that bond would be selling at discount, when the coupon rate is higher than the interest rate or YTM then the bond would be trading at a premium so in the above examples when the bonds are trading at a premium, that is their price is higher than the face value it is more likely because of the coupon rate which is higher than the interest rate so as long as the risk of the bond are similar, the expected return on bond would be same because they can be priced differently according to their expected future cash flows.