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Let’s try a practice question
An investor buys an 8.0% coupon bond to yield 7.0%. What will most likely happen to the price of the bond as maturity approaches?
- The price will decrease toward par.
- The price will increase toward par.
- The price will remain constant.
- The price will fall to zero. The correct answer here is A. What is Yield to Maturity or YTM?
Yield to Maturity is the the overall return of a bond if it is held until maturity. This calculation includes the gain or loss of a bond and takes into account current market price, par value, coupon and time to maturity.
What has happened to interest rates in the overall market in this question, between the time of issuance and the purchase of the bond? Rates went down. And we know that because the price of bonds has gone up. Rates down, prices up. Premium bonds. Prices went up, which means the yields go down. Let’s spend one minute here, breaking this thing down. The correct answer is “A.”
Let’s say there’s this 8% bond out here, all right? If you buy this bond for $1,200, what do you get back at maturity? $1,000. And all the while, every what, you receive what in interest? There are two potential answers here. So, every six months you receive $40. Did you earn 8% on this investment? You’re getting 8% a year, but are you going earn 8% on the whole thing? You’re not going to earn 8% because you must include what? You got 80, 80, plus 80. But what happens at the end? Minus $200. And this piece right here, is that going to increase, have no effect, or decrease your return? Put differently, will losing $200 in an investment help, hurt, or have no effect on your return? What do you all think? It’s going to hurt it. Driving the yield maturity down. That’s what happens here.
If you buy a bond at par and you get your 8% a year, and then at the end you get par, will making nothing extra and losing nothing, help, hurt, or do nothing to your return? If you buy a bond at par and you get par back, what’s your rate of return? The coupon. And you get 8% a year. And if you haven’t, what are you getting back if you buy this thing for $900? $1,000. Will getting, help, hurt, do nothing, to the return? Getting how much extra? $100 extra. That’s going to help us. Everybody see that’s going to help us. My return will be a yield to maturity will be higher or lower than the coupon? It’s got to be higher. Because that extra a hundred bucks is rolled up into my whole investment stream. Let me show it to you one more way.
A couple of questions came in. “Where do we get the $40 every six months?” 8% of a thousand equals $80 per year but paid in two equal semiannual payments of $40. Does that make sense? So let me show you this one more time, because this bond concept’s important one. Let’s say it’s a five-year bond, okay? Five-year bond. We got the $1200, we got the par, and we got the $900. And then every year we get 80 bucks, okay? Because I’m going to do this annually. Every year we get 80 bucks. And then what else happens at the end of the life of the bond? We lose 200. No gain or loss. And here we gain a hundred.
Which of these profiles do you like the best? Which of these do you think is the most attractive? You can do it a little bit differently. So this is investment. That’s money out, and this is return, money in. So here, you’re still going to get a thousand, right? But that is going to be a loss. You see the $200 in there? This is going to be a thousand, which means there’s a $100 gain in there. So, you can think about it in this capacity to show, all right, this has to be the best trade. But the thing is, you’re not able to buy 8% bonds at a discount when rates have fallen. These are not always available. Does that make sense to everybody? You only get to buy what’s in the market and that’s going To depend on what’s going on with rates.