Question

An investor must choose between two bonds: Bond A pays $73 annual interest and has a market value of $930. It has 10 years to maturity. Bond B pays $63 annual interest and has a market value of $920. It has two years to maturity. Assume the par value of the bonds is $1,000.

a. Compute the current yield on both bonds.

b. Which bond should she select based on your answer to part a?

c. A drawback of current yield is that it does not consider the total life of the bond. What is the yield to maturity on Bond B?

d. Has your answer changed between parts b and c of this question in terms of which bond to select?

Answer 1

a.

Current Yield = Annual Coupon/Bond Price

Current Yield of Bond A = 73/930 = 7.85%

Current Yield of Bond B = 63/920 = 6.85%

b.

One should choose Bond A as per Current Yield as it has higher current yield.

c.

Calculating YTM of Bond B,

Using TVM Calculation,

I = [PV = 920, FV = 1000, T = 2, PMT = 63]

I = 10.97%

YTM of Bond B = 10.97%

d.

The selection of Bond for investment has changed as YTM of Bond B is higher.

As YTM of Bond B is higher one should choose Bond B as investment option.