NASAA Series 66 Uniform Combined State Law ExaminationInvestment Vehicle CharacteristicsMedium
A portfolio manager is evaluating various debt securities for a client's fixed-income portfolio. They are considering a bond with a coupon rate of 5%, a par value of $1,000, and a current market price of $950. The bond matures in 10 years. Which of the following statements about this bond is TRUE?
- AThe bond's current yield is less than its coupon rate.
- BThe bond's yield to call (YTC) would be higher than its YTM.
- CThe yield to maturity (YTM) is higher than the coupon rate.
- DThe bond is trading at a premium.
Show answer & explanationAnswer & explanation
Correct answer: C. The yield to maturity (YTM) is higher than the coupon rate.
Since the bond is trading at a discount (market price $950 < par value $1,000), its yield to maturity (YTM) will be higher than both its coupon rate and current yield. When a bond trades at a discount, investors receive both the coupon payments and a capital gain at maturity, which increases the overall return.
Why the other options are wrong
- A. Current yield = Annual Interest / Current Market Price. (5% * $1000) / $950 = $50 / $950 = 5.26%. This is greater than the 5% coupon rate.
- B. If a bond is trading at a discount, its YTC would be lower than its YTM, as the bond is more likely to be called when interest rates fall, which would benefit the issuer but reduce the investor's return if called at par.
- D. Trading at $950, which is below its $1,000 par value, indicates it is trading at a discount, not a premium.
Bond Yields
Measures of the return an investor receives from a bond, including coupon rate, current yield, yield to maturity (YTM), and yield to call (YTC).
- Coupon Rate: Stated annual interest rate as a percentage of par value.
- Current Yield: Annual interest / Current market price.
- YTM: Total return if held to maturity, considering interest, capital gains/losses.
Memory trick: Price and Yield are always opposing forces, like a seesaw.