4. A bond fund manager has a four year time horizon, and is considering two bond
ID: 1186606 • Letter: 4
Question
4. A bond fund manager has a four year time horizon, and is considering two bonds. The first is a 15-year to maturity bond with a 6.60% coupon rate, paid annually. The price of this bond today is 100% of face value. The second bond is a 20-year to maturity bond issued 7% coupon rate, paid annually. The price of this bond is 101.05% of face value.
a. Calculate the yield to maturity for each bond.
b. The bond fund manager forecasts that, in four years, the 15-year bond will sell at a yield to maturity of 6.45% and the 20-year bond will sell at a yield to maturity of 6.70%. The bond fund manager also expects that the coupons can be reinvested at an annual rate of 4.75% over the period. Calculate the expected annualized compound rate of return over the five years for each bond. Which bond offers the higher expected compound rate of return?
Explanation / Answer
bond pricing. We want to emphasize, first, the
common misconception that there is a benefit to
receiving principal back at maturity. If that principal
is simply reinvested and not used to fund
a cash flow, there is no benefit in holding a bond
to maturity. Consider that the total return of
a laddered1 separate account with characteristics
identical to those of an open-end mutual fund
will deviate from the fund
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