Question

A 10-year corporate bond has an annual coupon of 9%. The bond is currently selling at par ($1,000). Which of the following statements is CORRECT? a. The bond’s expected capital gains yield is zero. b. The bond’s yield to maturity is above 9%. c. The bond’s current yield is above 9%. d. If the bond’s yield to maturity declines, the bond will sell at a discount. e. The bond’s current yield is less than its expected capital gains yield

Answer 1

Answer:

The answer is  (A)

Explanation:

Whenever a bond is being traded and redeemable at par value, the Yield to Maturity (YTM) is always the same as bond coupon rate. This can be demonstrated below :

Yr                                      CF             [email protected]%    PV          [email protected] 5%       PV

                                          $                                $                                 $

0   Market Price              (1000)           1            (1000)          1             (1000)

1-10 Gross Interest           90            6.145*      553.05      7.722**    694.98

10  Redemption Value     1000        0.386       386           0.614       614    

                                                                         (60.95)                       308.98

*Using 10 years annuity discounting factor at 10%

** Using 10 years annuity discounting factor at 5%

YTM( Using IRR formula)= Lr+  (NPV+)÷ ( (NPV+) -(NPV-) ) *(Hr-Lr)

                                   =5%+ (308.98) ÷ ( (308.98) -(-60.95) ) * (10-5)%

   Hence, YTM          =9.18%

                              ≅ 9%

Option (A)  This is true. A bond that is traded and redeemable at par value will not have any capital gain. Capital gains can only be realised when the redemption value is greater than the market price which implies that the bond holder is getting another return in addition to interest element.

In this case, the bond holder will only settle for returns accrued from higher coupon which is the only attractivess of this type of bond.

Option (B) .This is false. The bond YTM as calculated above is 9%

Option (C). This is false. The bond current yield is 9%.

Option (D). This is false. The bond current yield is 9% which is greater than capital gains that is currently zero.

                   

Answer 2

Answer:

a. The bond’s expected capital gains yield is zero.

Explanation:

Since the bonds are issued at par so capital gains yield is zero.