Question

Consider a five-year bond with a 10% coupon selling at a yield to maturity of 8%. If interest rates remain constant, one year from now the price of this bond will be:

A. Higher

B. Lower

C. The same

D. Par

Answer 1

The correct answer is Option B(Lower).

Here is why

The coupon rate of this bond is 10% and Yield To maturity is 8%. Clearly, Coupon Rate > Yield to Maturity

That is why this bond will be selling at a premium. But If interest rates remain constant, one year from now the price of the bond will be lower due to the fact that Bond Price approaches its par value as the time to maturity approaches its maturity date. We can understand this with help of an example. Let's say a bond has a par value of $1000 and a coupon rate of 8% and YTM is 6%, we shall be calculating the bond price in two cases; first when the bond has a life of 10 years and secondly when bond has a life of 5 years. Let's calculate the bond price: As we can see the bond value has reduced from $1147.20 to $1084.25 when time period changed from 10 to 5 years, that is the bond has started approaching the par value. Its price is lower now.