Bond concepts Answer: d Diff: E N

21. Bond yield Answer: a Diff: E

If the bond sells at a premium, its price will decline as it approaches maturity. (Remember that at maturity it has to be worth its par value.) Therefore, statement a is true. The current yield is defined as the coupon payment divided by the price. If the bond is selling at a premium, then its price will have to decline over time. If its price is declining, then there is a negative capital gains yield. Remember that YTM will equal the capital gains yield plus the current yield. Therefore, for YTM to be 8 percent with a negative capital gains yield, the current yield must be higher than 8 percent. Therefore, statement b is false. If the bond is trading at a premium and the YTM is constant, it will have to slowly decline in value until, just at maturity, it is worth its par value. Therefore, statement c is false. If the bond’s coupon rate were less than the YTM, it would be less valuable than new bonds issued at the YTM and would, therefore, trade at a discount, not a premium. Therefore, statement d is false. If the YTM increases, then this bond’s cash flows (coupons) will be discounted at a higher rate and will be worth less. Therefore, the price will decrease, not increase. Therefore, statement e is false.

22. Bond yields and prices Answer: d Diff: E

If the YTM is 7 percent, this is the market interest rate. Therefore, Bond A’s coupon rate is higher than the market rate, so it must be selling above par (at a premium). Bond B’s coupon rate is lower than the market rate, so it must be selling below par (at a discount).

Statement a is false. If the YTM remains the same, the price of Bond A will fall, and the price of bond B will rise. The total yield of

7 percent on both bonds will consist of a capital gains yield and a current yield. The sum of these two yields will be 7 percent. Statements b, c, and e are false for the reason mentioned above. Therefore, the correct answer is statement d.

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