Answer:
a. Compute the current yield on both bonds.
Current yield = Annual coupon payment / current market price of bond
Bond A current yield = $80 / $800 = 0.1
Bond B current yield = $85 / $900 = 0.09
b. Which bond should he select based on your answer to part a?
Bond A, because it has a higher current yield.
What is the approximate yield to maturity on Bond B?
Approximate Yield to Maturity (YTM) = [C+ (F-P) / n] / [(F+P) / 2]
Where:
C = Coupon payment
F = Face value
P = Price
n = years to maturity
Because the face value is not specified in the question, we will assume is the same as the price.
Bond B YTM = [85 + (900-900) / 2] / [(900+900) / 2]
= 0.09
d. Has your answer changed between parts b and c of this question in terms of which bond to select?
Under the assumption that the price and face value of Bond b are the same, we can see that the YTM and the current yield are the same, so the choice of the bond (bond A) has not changed.
However, if the face value was higher or lower than the price, the YTM would be different to the current yield, for that reason, it is always best to check Yield to Maturity instead of current yield when choosing which bond to invest in.
