Question

4. You read the following statement in a financial report: "The company purchased a zero coupon bond three years ago at its par value of $100,000 and five years remaining to maturity. The market price of this debt obligation today is $75,000. The decline in the value of the obligation is mainly due to two factors: an increase in market yields for comparable instruments and the decrease in the time to maturity. Another reason has been the sudden steepening of the yield curve. Even if the Fed has not made a move on short term rates, this change led to declines in bond prices" Which portions of the statement seem reasonable or unreasonable? Explain clearly.

Answer 1

The present value of a 3 year old bond today is $75,000 i.e. a decline of $25,000 over the period. The decline can be due to below factors:

1) An Increase in market yield: Bond prices and yield move in opposite direction, when yield increases bond prices decreases. for example a 2% bond will have more discount rate than a 5% bond. Hence this statement seems reasonable.

2) Decrease in time to maturity: Decrease in time to maturity makes the bond more attractive as the duration is less and hence the scope for interest rate fluctuation in the market is also less. Hence this statements seems unreasonable.

3) Sudden steepening of yield curve: It means that the spread between long term interest rate and short term interest rate is increasing, hence yields are more in long term bond, resulting in declining value of short term bond. Hence this statement seems reasonable.