Question

A bond investor is analyzing the following annual coupon bonds: Annual Coupon Rate 6% Issuing Company Smith Enterprises Irwin Incorporated Johnson Metalworks 12% 9% Each bond has 10 years until maturity and has the same risk. Their 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 1000 900 600 10 8 6 4 2 0 YEARS TO MATURITY Based on the preceding information, which of the following statements are true? Check all that apply. Johnson's bonds are a better investment than Irwin's bonds. O All of the bonds will have the same value when they reach maturity. The expected capital gains yield for Smith's bonds is positive. Irwin's bonds are a better investment than Smith's bonds. If a bond is selling for a price much lower than its par value, it is most likely that the bond is bond.

Answer 1

For this question,

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.

Smith's bond have coupon rate of 6%, less than YTM 9%. Hence its price would be less than par value, and would increase as it moves towards maturity. So represented by BLUE LINE.

Irwin's bond have coupon rate of 12%, more than YTM 9%. Hence its price would be more than par value, and would decrease as it moves towards maturity. So represented by ORANGE LINE.

Johnson's bond have coupon rate of 9%, equal to YTM of 9%. Hence its price would be equal to par and remain the same as it moves to maturity. So represented by GREEN LINE.

Correct statement are - Statement 2 and 3.

Statement 1 and 4 are incorrect as all bonds have the same total expected return of 9% which is shown by their YTM. So no one bond is better than another

If a bond is selling for a price much lower than its par value, it is most likely that the bond is outstanding bond.