Question

Last year, the yield on AAA-rated corporate bonds averaged approximately 5 percent; one year later, whereas this year the yield on these same bonds had climbed to about 6 percent because the Federal Reserve increased interest rates during the year. Assume that IBM issued a 10-year, 5 percent coupon bond one year ago (on January 1). On the same date, Microsoft issued a 20-year, 5 percent coupon bond. Both bonds pay interest annually and each has a par value of $1,000. Also assume that the market rate on similar risk bonds was 5 percent at the time that the bonds were issued.
a. Compute the market value of each bond at the time of issue.
b. Compute the market value of each bond one year after issue if the market yield for similar risk bonds was 6 percent.
c. Compute the capital gains yield for each bond during the year.
d. Compute the current yield for each bond during the year.
e. Compute the total return that each bond would have generated for investors during the year.
f. If you invested in bonds at the beginning of the year (January 1 one year ago), would you have been better off if you held long-term or short-term bonds? Explain.
g. Assume that interest rates stabilize at rate of 6 percent, and then they stay at this level indefinitely. What would be the price of each bond after six years have passed? Describe what should happen to the prices of these bonds as they approach their maturities.

Answer 1