A bond investor is analyzing the following annual coupon bonds Issuing Company J

Question

A bond investor is analyzing the following annual coupon bonds Issuing Company Johnson Enterprises Smith Incorporated Irwin Metalworks Annual Coupon Rate 5% 12% 9% Each bond has 10 years until maturity and has the same risk. Their yield to maturity (YTM) is 9%. Interest rates are assumed to remain constant over the next 10 years. Label the curves on the following graph to indicate the path that each bond's price, or value, is expected to follovw BOND VALUE ($ 1200 1100 1000 900 800 700 600 10 YEARS TO MATURITY Based on the preceding information, which of the following statements are true? Check all that apply The current yield for Smith's bonds is between 0% and 9% Irwin's bonds are selling at par Smith's bonds have the highest expected total return The current yield for Smith's bonds is greater than 9% If a bond is selling for a price much lower than its par value, it is most likely that the bond is bond

Explanation / Answer

Part 1:

The relationship between bond price, coupon and YTM are:

- If coupon rate > YTM, bond price is higher than par value and hence bond trades at a premium.

- If coupon rate < YTM, bond price is lower than par value and hence bond trades at a discount.

- If coupon rate = YTM, bond price is equal to par value

As bond matures, the price of bond moves towards it par value. So, for a discount bond, price of a bond increases as it moves to maturity. For a premium bond, price of a bond decreases as it moves towards maturity. For par value bonds, it remains the same.

So, evidently in graph, orange line is the premium bond, where YTM < Coupon Rate which is Smith Inc

Green line represents the bond trading at par, so YTM = Coupon rate, which is Irwin Metalworks

Blue line represents the bond trading at discount, so YTM > Coupon rate, which is Johnson Enterprise

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Correct statements are: Statement 2, Statement 4.

Statement 1 is incorrect because Smith's bonds are trading at premium. They will have a negative capital gains yield since the bond price will decline to par value by maturity. But, total return would have to be YTM = 9% on all bonds. So, in order to have the total return as 9%, current yield for the bond would be higher than 9% (negative capital gain yield could be nullified by higher current yield).

If a bond is selling for a price lower than its par value, it is most likely a SEASONED bond. Had it beena new issuance, coupon rate has been closer or almost equal to YTM, and hence price would have been closer to par value.

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