Question

Two bonds A and B have the same credit rating, the same par value and the same coupon rate. Bond A has 30 years to maturity and bond B has 5 years to maturity.

- Discuss which bond will trade at a higher price in the market

- Discuss what happens to the market price of each bond if the interest rates in the economy go up.

- Which bond would have a higher percentage price change if interest rates go up?

- Try to substantiate your argument with a numerical example.

As a bond investor, if you expect slowdown in the economy over the next 12 months, what would be your investment strategy?

Answer 1

Let us assume following values for each bond
Bond A:
par value=1000 coupon=6% and payable annually time=30 ytm=8%
use below formulae to find price of bond
a) Price=(coupon*(1-((1+i)^-n))/i)+(issue price*(1+i)^-n)
coupon=6%*1000=60
n=30
i=8%
issue price=1000
price=774.84
Bond B:
coupon=6%*1000=60
n=5
i=8%
issue price=1000
price=920.15
Bond B trades at higher price in market
b)let YTM goes to 10%
Bond A:
coupon=6%*1000=60
n=5
i=10%
issue price=1000
price=622.92
Bond B:
coupon=6%*1000=60
n=5
i=10%
issue price=1000
price=848.37
Both the bonds price will come down
c)% change=(final/initial)-1
Bond A=(622.92/774.84)-1=-19.61%
Bond B=(848.37/920.15)-1=-7.80%
highest % change is for Bond A

d)Sell Bond B and hold Bond A