Which of the following statements is CORRECT? (Points : 10)
If a bond is selling at a discount, the yield to call is a better measure of return than the yield to maturity.
On an expected yield basis, the expected capital gains yield will always be positive because an investor would not purchase a bond with an expected capital loss.
On an expected yield basis, the expected current yield will always be positive because an investor would not purchase a bond that is not expected to pay any cash coupon interest.
If a coupon bond is selling at par, its current yield equals its yield to maturity.
The current yield on Bond A exceeds the current yield on Bond B; therefore, Bond A must have a higher yield to maturity than Bond B.
To determine which of the following statements is correct, we need to analyze each statement individually:
1. "If a bond is selling at a discount, the yield to call is a better measure of return than the yield to maturity."
To evaluate this statement, we need to understand the concepts of "yield to call" and "yield to maturity." The yield to call represents the return an investor would earn if they hold the bond until it is callable, which is when the issuer has the option to redeem the bond before its maturity date. On the other hand, the yield to maturity represents the return an investor would earn if they hold the bond until its maturity date.
If a bond is selling at a discount, it means its market price is lower than its face value. In this case, the yield to call may be a better measure of return because it considers the potential early redemption at the call price, which is typically higher than the market price. However, it is important to note that this statement does not apply to all situations, as it depends on the specific terms and conditions of the bond.
2. "On an expected yield basis, the expected capital gains yield will always be positive because an investor would not purchase a bond with an expected capital loss."
To assess this statement, we need to understand the concept of "expected yield" and "capital gains yield." The expected yield takes into account the potential future income and price appreciation of a bond. The capital gains yield specifically refers to the potential increase in the bond's price.
While it is generally true that investors would prefer not to purchase bonds with an expected capital loss, it does not mean that the expected capital gains yield will always be positive. The expected capital gains yield can be positive, zero, or negative depending on various factors, including market conditions, interest rate changes, and credit risk. Therefore, this statement is not always correct.
3. "On an expected yield basis, the expected current yield will always be positive because an investor would not purchase a bond that is not expected to pay any cash coupon interest."
To evaluate this statement, we need to understand the concept of "expected current yield." The current yield represents the annual interest payment (coupon) divided by the bond's market price, expressed as a percentage.
This statement is generally correct. If an investor expects a bond to not pay any cash coupon interest, the expected current yield would be zero. In practice, most investors would not purchase a bond that is not expected to generate any cash coupon interest, as it would not provide regular income. However, it is important to note that this statement assumes that there are no other potential sources of return or appreciation from holding the bond.
4. "If a coupon bond is selling at par, its current yield equals its yield to maturity."
To assess this statement, we need to understand the concept of "coupon bond," "selling at par," "current yield," and "yield to maturity." A coupon bond is a bond that pays periodic interest (coupon) payments. Selling at par means that the bond is trading at its face value, which is typically $1,000. The current yield represents the annual interest payment (coupon) divided by the bond's market price, expressed as a percentage. The yield to maturity represents the total return an investor would earn if they hold the bond until its maturity date, taking into account the coupon payments and any potential capital gains or losses.
If a coupon bond is selling at par, it means that its market price is exactly equal to its face value. In this case, the current yield would be equal to the coupon rate divided by the face value. Additionally, the yield to maturity would also be equal to the current yield and the coupon rate, as there would be no potential capital gains or losses since the bond is selling at par. Therefore, this statement is correct.
5. "The current yield on Bond A exceeds the current yield on Bond B; therefore, Bond A must have a higher yield to maturity than Bond B."
To evaluate this statement, we need to understand the concept of "current yield" and "yield to maturity." The current yield represents the annual interest payment (coupon) divided by the bond's market price, expressed as a percentage. The yield to maturity represents the total return an investor would earn if they hold the bond until its maturity date, taking into account the coupon payments and any potential capital gains or losses.
This statement is not necessarily correct. While the difference in current yield between two bonds can provide an indication of their relative yields, it does not directly determine their yield to maturity. The yield to maturity considers the impact of the bond's market price, coupon payments, and potential capital gains or losses upon maturity. Therefore, there can be instances where Bond A has a higher current yield but a lower yield to maturity compared to Bond B, depending on their specific characteristics.