Question

Issuing Company Irwin Enterprises Johnson Incorporated Smith Metalworks Annual Coupon Rate 6% 12% 9% Each bond has 10 years until maturity and has the same risk. The bonds' yield to maturity (YTM) is 9%. Interest rates are assumed to remain constant over the next 10 years. Label the curves on the following graph to indicate the path that each bond's price, or value, is expected to follow. BOND VALUE ($1 1200 1100 Smith Johnson Irwin 1000 600 10 8 6 4 20 YEARS TO MATURITY

Answer 1

This question requires application of relationship between coupon rate, YTM and bond price.

When coupon rate > YTM, bond price > par value. This is a premium bond. Its value will decline and move towards par value as we move towards maturity.

When coupon rate < YTM, bond price < par value. This is a discount bond. Its value will increase and move towards par value as we move towards maturity.

When coupon rate = YTM, bond price = par value. This is a par bond.

For Irwin Enterprises, coupon rate (6%) < YTM (9%). Hence, this would be a discount bond, with current value less than par. Hence this is the blue line in graph.

For Johnson Inc, coupon rate (12%) > YTM (9%). Hence, this would be a premium bond, with current value greater than par. Hence this is the orange line in graph.

For Smith Metalworks, coupon rate (9%) = YTM (9%). Hence, this would be a par bond, with current value equal to par. Hence this is the green line in graph.

Correct statements are - 1 and 3

Statement 2 is incorrect as all bonds have same expected return (=9%).

Statement 4 is incorrect. As Johnson is a premium bond, it will have a negative capital gains yield. But since the total return (or YTM) is 9%, this implies current gain yield has to be higher in order to compensate for the negative capital gains yield.

Smith's bonds have had substantial trading volume in past few years. Its bonds would be referred to as SEASONAL ISSUE.

Given it has been traded for few years now, it cannot be a new issue.