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 I$ 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 Irwin's bonds are a better investment than Smith's bonds All of the bonds will have the same value when they reach maturity Smith's bonds are a better investment than Johnson's bonds The expected capital gains yield for Johnson's bonds is positive. 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

An inverse relationship exists between YTM and bond prices.

YTM > Coupon rate, bond price will be lower than par value. This is a bond trading at DISCOUNT.

YTM < Coupon rate, bond price will be higher than par value. This is a bond trading at PREMIUM.

YTM = Coupon rate, bond price will same as par value.

In Graph,

orange line represents: Smith Inc. Coupon rate (12%) > YTM (9%) - hence bond would be trading at premium before maturity

Green line represents: Irwin Metalworks. Coupon rate (9%) = YTM (9%). hence bond would trade at par over its life.

Blue line represents: Johnson Enterprises. Coupon rate (6%) < YTM (9%) - hence bond would be trading at discount before maturity

Correct statements are: Statement 2 and Statement 4.

All bond would have their value at par when they mature, whatever their prices be before maturity. Hence, statement 2 is correct.

Johnson's bond is currently trading at discount and would reach par value till maturity. This implies, its capital yield would be positive. Hence, statement 4 is correct.

All bonds have an effective yield of 9%, hence, total returns on all bond will be 9%. So, no one bond is better than other.

If a bond is selling for a price much lower than its par value, it is most likely that the bond is OUTSTANDING bond. {For a newly issued bond, price of bond may not be much lower than par value, given the coupon rates would be decided based on current market interest rate or YTM and hence is expected to be closer to par value}

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