Your broker has just called and offered you the choice of two bonds. Both Bonds

Question

Your broker has just called and offered you the choice of two bonds. Both Bonds have a face value of $1,000. Bond A does not have a Call Provision, matures in seven (7) years, carries a Coupon Rate of 4.62% and has a market price of $1,005. Bond B matures in fifteen (15) years, carries a Coupon Rate of 4.25%, has a market price of $1,000, but has a Call Provision for all the Bonds in seven (7) years. The Call Premium is 4.0%. Interest rates have been coming down, the Federal Reserve Bank has said they will continue to lower rates, and both you and your broker are convinced that Bond B will be called in seven (7) years. Which bond will provide you a better yield? What is the Yield to Maturity on Bond A? What is the Yield to Maturity on Bond B? What is the 7-year Yield to Call on Bond B? Which bond should you buy? Answer exactly with either "Bond A" or "Bond B", without the quotation marks of course.

Explanation / Answer

Calculation of Yield to Maturity on Bond A:

Formula:

Yield to maturity = (C + (F-P) /n) / ((F+P)/2)

C= Coupon Payment = Face value * Coupon rate = $1000*4.62% = $46.2

F = Face value = $1000

P =Price of Bond = $1005

n = number of years to maturity = 7

Hence,

Yield to maturity = (46.2 + (1000-1005) /7) / ((1000+1005)/2)

= (46.2 - 0.71429) / 1002.5

= 0.045372

= 4.54%

Hence Yield to Maturity is 4.54%

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