An investor must choose between two bonds: Bond A pays $80 annual interest and h

Question

An investor must choose between two bonds:

Bond A pays $80 annual interest and has a market value of $800. It has 10 years to maturity.

Bond B pays $85 annual interest and has a market value of $900. It has two years to maturity.

a. Compute the current yield on both bonds.

b. Which bond should he 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 approximate yield to maturity on Bond A is 11.36 percent. What is theapproximate 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?

Enter formulas to complete the requirements of this problem.

         

Annual Market Years to Interest Value Maturity Bond A $80 $800 10 Bond B $85 $900 2

Explanation / Answer

SIMILAR QUESTION:

Bond A pays $92 annual interest and has a market value of $875. It has 10 years to maturity. Bond B pays $82 annual interest and a market value of $900. It has 2 years to maturity.

a. Compute the current yield on both bonds

How to get this answers?

A current yield = 10.51%

B current yield = 9.11%

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

Bond A @ 10.51%

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 11.30%. What is the approximate yield to maturity on bond B?

Bond A = 11.3%

bond B = 14.04%

bond B has substantial amount of return

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

ANSWER:

---------------

a) Current yield = Interest divided by Market Value

Bond A - $92 divided by $875 = 10.51%

Bond B - $82 divided by $900 = 9.11%

b) Based on current yield (only) Bond A pays a higher rate of interest so that would be the one to choose.

Note before C: remember that the bonds here have a Par Value of $1,000.

c) Yield to maturity (YTM) = Annual Interest Payment + (Par Value - Market Value)/Number of Years until Maturity divided by

(Par Value + Market Value)/2

So for bond A $92 + ($1,000 - $875)/10 divided by ($1,000 + $875)/2 or $92 + $125/10 divided by $1,875/2 or $92 + $12.50 divided by $937.50 or $104.50 divided by $937.50 which comes to 11.15% (I disagree with the 11.30% answer in your question description)

And for Bond B $82 + ($1,000 - $900)/2 divided by ($1,000 + $900)/2 or $82 + $100/2 divided by $1,900/2 or $82 + $50 divided by $950 or $132 divided by $950 which comes to 13.89% (I disagree with the 14.04% in your question description)

d) Yes, our answer changed. Based on interest over the duration of the life of the bonds (or TO MATURITY), bond B actually pays a higher rate of interest, so Bond B is really the better deal.

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