Question

Explain how can a bond with a coupon rate of 10% and being sold at par offer the same return to the investor as a bond paying interest of 6% per year and selling below par, assuming that both are held until maturity?

Answer 1

Let take an example a bond is paying annual coupon of 10% with face value of 100 and mature in 2 years. Current yield to maturity is 10%. Since the maturity rate and coupon rate is same we can say that bond is selling at par. If some one hold it till maturity he will get 105 of return.

Similarly take another bond which is also going to mature in 2 years with 6% coupon rate and yield to maturity will be 10% also , as we know bond price is inversly proportional to the yiedl to maturity. One can easily say that at 10% yield to maturity 6% coupon bond will be selling below par.

Lets take this now

Bond price = 6/1.1 + 106/1.1

= $ 93.05

Since the bond price is les than 100 if someone hold till maturity and he will get the capital gain on the bond as well as the coupon interest rate that will be equal to the 10%. So in this case as well there will be 10% of return as equal to par bond.

answered by: anonymous