Question

An investor must choose between two bonds:

Bond A pays $90 annual interest and has a market value of $820. It has 10 years to maturity.

Bond B pays $95 annual interest and has a market value of $920. It has six years to maturity.

Assume the par value of the bonds is $1,000.

a. Compute the current yield on both bonds. (Do not round intermediate calculations. Input your answers as a percent rounded to 2 decimal places.)
  

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

	Bond A
	Bond B

c. A drawback of current yield is that it does not consider the total life of the bond. For example, the approximate yield to maturity on Bond A is 12.11 percent. What is the approximate yield to maturity on Bond B? The exact yield to maturity? (Use the approximation formula to compute the approximate yield to maturity and use the calculator method to compute the exact yield to maturity. Do not round intermediate calculations. Input your answers as a percent rounded to 2 decimal places.)
  

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

Answer 1

Part a:

Current yield=Annual coupon/Current bond price

For bond A:
Given that, annual coupon interest payment=$90
Current market value of the bond=$820
Current yield=$90/$820=0.109756098 or 10.98% (Rounded up to two decimal places)

For bond B:
Given that, annual coupon interest payment=$95
Current market value of the bond=$920
Current yield=$95/$920=0.10326087 or 10.33% (Rounded up to two decimal places)

Part b:
Bond A should be selected because it has higher current yield.

Part c:

Approximate yield to maturity on Bond B=[Annual coupon payment+(Par value-Market value)/Time to maturity]/[(Par value+Market value)/2]
Given that;
Annual coupon payment=$95
Par value=$1,000
Market value=$920
Time to maturity=6
Substituting the values in the equation, we get:
Approximate yield to maturity on Bond B=[95+(1000-920)/6]/[(1000+920)/2]
=[95+(80)/6]/[(1920)/2]
=[95+13.33333333]/[960]
=108.3333333/960=0.112847222 or 11.28% (Rounded up to two decimal places)

As present value is a cash outflow, it is shown with a negative sign.

Exact yield to maturity as calculated using excel=11.41%

Part d:

In answer to question b, current yield on bond A is 10.98% and current yield on bond B is 10.33%. So bond A looks more attractive.

If the approximate yield to maturity on bond A is 12.11% as given in question c, comparing it will the yield to maturity on bond B (equal to 11.28% or 11.41%). Bond A still remains more attractive.

When we compare between the current yield on bond A (that is 10.98%) in question b, and yield to maturity on bond B (equal to 11.28% or 11.41%) in question d, bond B looks more attractive. Yes, in this case, our answer will change from bond A to bond B.