Question

You are considering investing in one of the following two bonds. Discuss your thought process (supported by numbers) for making this decision.

Bond A:                                                           Bond B:

Coupon ->9%, annual payments                      Coupon ->4%, annual payments

Maturing ->10 years                                         Maturity ->5 years

YTM -> 6%                                                     YTM -> 6%

Answer 1

Present value of Bond= Present value of interest payments + Present value of Par value

Let's assume Bond par vaue for both the bonds is 100

Bond A Present value

=9/1.06¹+9/1.06²+9/1.06³+9/1.06⁴+9/1.06⁵+9/1.06⁶+9/1.06⁷+9/1.06⁸+9/1.06⁹+9/1.06¹⁰+100/1.06¹⁰

=9*7.360+100*0.558

=66.24+55.8

=122.04

Bond B Present value

=40/1.06¹+40/1.06²+40/1.06³+40/1.06⁴+40/1.06⁵+100/1.06⁵

=40*4.212+100*0.747

16.848+74.7

=91.548

Bond A: If a bond's coupon rate(9%) is more than its YTM(6%), then the bond is selling at a premium.(122.04). It means company is paying you higher than what market is offering.

Bond B : If a bond's coupon rate(4%) is less than its YTM(6%), then the bond is selling at a discount.(91.548). It means market is paying more than what the company is offering..

If a bond's coupon rate is equal to its YTM, then the bond is selling at par.

A longer-term bond(10 years) carries greater risk that higher inflation could reduce the value of payments, as well as greater risk that higher overall interest rates could cause the bond's price to fall.

Considering the above facts, investor should invest in Bond A.