NASAA Series 66 Uniform Combined State Law ExaminationInvestment Vehicle CharacteristicsMedium
An investor owns a bond with a 5% coupon rate, a par value of $1,000, and 10 years to maturity. If the bond is currently trading at a premium with a yield to maturity (YTM) of 4.5%, what would be the approximate impact on the bond's price if interest rates in the market were to suddenly increase?
- AThe bond's price would remain unchanged.
- BThe bond's price would increase.
- CThe bond's price would increase, but its YTM would decrease.
- DThe bond's price would decrease.
Show answer & explanationAnswer & explanation
Correct answer: D. The bond's price would decrease.
Bond prices and interest rates have an inverse relationship. When interest rates in the market rise, newly issued bonds offer higher yields, making existing bonds with lower coupon rates less attractive. To compete, the price of existing bonds must fall.
Why the other options are wrong
- A. Bond prices are sensitive to interest rate changes and would not remain unchanged.
- B. An increase in interest rates generally causes bond prices to fall, not rise.
- C. An increase in interest rates would cause bond prices to decrease, and YTM would likely increase to match the new market rates, not decrease.
Bond Price-Interest Rate Relationship
Bond prices move inversely to interest rates. When interest rates rise, bond prices fall, and vice versa.
- Existing bonds become less attractive when new bonds offer higher yields.
- To compensate, the market price of existing bonds must adjust.
- This inverse relationship is fundamental to bond valuation.
Memory trick: Rates up, prices down; rates down, prices up.