- Which statement is true regarding the yield of a zero-coupon bond?
Answer: Its nominal yield is zero.
A zero-coupon bond does not make periodic interest payments. Its coupon rate, and therefore its nominal yield, is 0%. An investor's return comes from the appreciation of the bond's price from the discounted purchase price to the par value at maturity.
- A broker informs a client that a particular bond has a yield to maturity of 5.5% and a coupon rate of 4.5%. The bond is most likely trading:
Answer: at a discount.
When the yield to maturity (YTM) is greater than the coupon rate (nominal yield), it means the investor's total return is supplemented by a capital gain at maturity. This only occurs when the bond is purchased for less than its par value, i.e., at a discount.
- A U.S. Treasury note is purchased with a yield to maturity of 3.5%. This means the investor will receive:
Answer: a total annualized return of 3.5% if the note is held to maturity.
Yield to maturity (YTM) represents the total anticipated return on a bond if it is held until it matures. This return includes all interest payments from the coupon plus any capital gain or loss (the difference between the purchase price and par value). It is expressed as an annualized percentage.
- A corporation would be most likely to call its outstanding bonds when:
Answer: interest rates are falling.
Issuers call bonds to their advantage. They will do so when interest rates have fallen significantly, allowing them to redeem the higher-coupon bonds and issue new bonds at the lower prevailing rates, thereby reducing their interest expense.
- A corporate bond with a 6% coupon is trading at a price of 95. Which of the following statements regarding its yields is correct?
Answer: The yield to maturity is greater than the current yield.
When a bond trades at a discount (price below 100), the order of its yields from highest to lowest is: Yield to Maturity (YTM), Current Yield (CY), and Nominal Yield (NY). Therefore, the YTM is greater than the current yield.
- For which of the following bonds would an investor be most interested in the yield to call (YTC)?
Answer: A 7% bond trading at 108, callable at 102.
Yield to call is the most relevant yield calculation for a bond trading at a premium that is likely to be called by the issuer. The issuer would call the 7% bond to refinance at lower rates. For discount bonds, YTM is more relevant, and for a bond at par, YTC and YTM are the same.
- If a bond is purchased at its par value, which of the following statements is true regarding its yields?
Answer: The nominal yield, current yield, and yield to maturity are all equal.
When a bond is purchased at par ($1,000), the investor pays face value. Therefore, the nominal yield (coupon rate), current yield (annual interest / market price), and yield to maturity (total return) are all the same.
- A 20-year, 8% corporate bond is callable in 5 years at 102. If the bond is currently trading at 106, which yield would be the lowest?
Answer: Yield to Call
For a bond trading at a premium, the yields are ranked from highest to lowest: Nominal Yield (8%), Current Yield (80/1060 = 7.55%), Yield to Maturity, and Yield to Call. The YTC is the lowest because the investor pays the largest premium (106) but may only get back the call price (102) in a shortened time frame, reducing the overall return.
- An investor buys a 5% corporate bond with a par value of $1,000 at a price of $900. What is the bond's current yield?
Answer: 5.56%
Current yield is calculated as the annual interest payment divided by the current market price. The annual interest is 5% of $1,000 par, which is $50. The current yield is $50/$900=0.0555.Ë™., or 5.56%. - An investor is analyzing a 10-year bond with a 6% coupon, trading at 104. The bond is callable in 3 years at 101. To make a conservative investment decision, the investor should primarily consider the:
Answer: yield to call.
For a bond trading at a premium, the yield to call (YTC) will be lower than the yield to maturity (YTM). This represents the 'yield to worst,' or the most conservative potential return, as the issuer is likely to call the bond at the first opportunity. Therefore, a prudent investor would focus on the YTC.
- The difference between the yield on a corporate bond and the yield on a Treasury bond with a similar maturity is known as the:
Answer: credit spread.
The credit spread, or yield spread, represents the additional yield that investors demand for bearing the credit risk of a corporate issuer compared to the 'risk-free' rate of a U.S. Treasury security of the same maturity. A wider spread indicates higher perceived risk.
- A 10-year bond with a 5% coupon is quoted at 101. This bond is trading at:
Answer: a premium, and its YTM is less than 5%.
A price quote over 100 (par) means the bond is trading at a premium. For any bond trading at a premium, its yield to maturity (YTM) will be lower than its nominal yield (coupon rate), which is 5% in this case.
- All other factors being equal, which of the following bonds will experience the greatest price percentage change in response to a 1% change in market interest rates?
Answer: A bond with a 20-year maturity.
Longer-term bonds have greater price volatility (or duration) than shorter-term bonds. This means their prices are more sensitive to changes in interest rates. Therefore, the 20-year bond will experience the largest price fluctuation.
- The existence of a call feature on a bond is most advantageous to the:
Answer: issuer, because it allows them to refinance debt at lower rates.
A call feature gives the issuer the right, but not the obligation, to redeem the bond before its scheduled maturity date. This is advantageous to the issuer, as it provides the flexibility to refinance its debt if interest rates fall.
- If prevailing interest rates in the market increase, what is the most likely impact on the price of existing bonds?
Answer: The prices will decrease.
There is an inverse relationship between interest rates and the prices of existing bonds. When new bonds are being issued with higher interest rates (yields), existing bonds with lower fixed coupons become less attractive, causing their market prices to fall.
- An investor holds several high-coupon corporate bonds that are called by the issuer during a period of declining interest rates. The investor now faces which primary risk when trying to replace this income stream?
Answer: Reinvestment risk
Reinvestment risk is the risk that an investor will not be able to reinvest cash flows (like interest payments or principal from a called bond) at a rate comparable to their current rate of return. This risk is most acute when interest rates are falling.
- Two bonds have the same maturity date and credit quality. Bond A has a 2% coupon, and Bond B has a 6% coupon. If interest rates fall by 1%, which bond will experience a greater percentage increase in price?
Answer: Bond A
Bonds with lower coupons have longer durations and are more sensitive to changes in interest rates. A larger portion of the low-coupon bond's total return comes from the principal repayment at maturity, making its present value more affected by interest rate changes. Therefore, Bond A will experience a greater price increase.
- An investor purchased a bond when its yield to maturity was 5%. A year later, the bond's yield to maturity is 4%. Assuming no change in the bond's credit quality, the market price of the bond has most likely:
Answer: increased.
Bond prices and yields move in opposite directions. Since the bond's yield to maturity has decreased from 5% to 4%, its market price must have increased.
- An investor purchases a $1,000 par value bond with a stated interest rate of 7%. The bond is currently trading at 103. What is the nominal yield of this bond?
Answer: 7.00%
The nominal yield, also known as the coupon rate, is the fixed annual interest rate stated on the face of the bond. It does not change with the market price of the bond. In this case, it is 7%.
- During a period of economic expansion, a central bank is expected to tighten monetary policy. This action would most likely cause the yields on existing bonds to:
Answer: increase, and their prices to decrease.
Tightening monetary policy generally involves raising interest rates to combat inflation. When benchmark interest rates rise, the yields on existing bonds must also rise to remain competitive. Due to the inverse relationship between yield and price, an increase in yields will cause the prices of existing bonds to decrease.
