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frigate1985's avatar

Does Bond Valuation use Yield to Maturity or Expected Rate or Return?

Asked by frigate1985 (927points) May 20th, 2016

I am learning basic finance, and while working through some practice problems, I ran into some problems.
The question is:
A year ago, I bought two bonds by the same company. One is a 20 year maturity with $1000 par value, with annual coupon of 7%, and the second one is a 5 year maturity with the same par value and same coupon rate. Both had a yield to maturity (=required rate of return) of 9% when I bought them.
b. Today, assume the yield to maturity on both bonds is 11%. What is the total rate of return on each bond if you sell these bonds today?
c. now imagine today’s yield to maturity is 13% for each bond. What is the total rate of return on each bond if you sell these bonds today?

So basically, assuming that we use the required rate of return to compute bond prices, we would have the same answer for both questions. The professor gave us different YTM values, which seems to suggest that we need to use YTM, but using YTM values actually drops the bond price further away from the par value, which doesnt make sense. But if we use the same 9% required rate, the answer is substantially the same.

What am I missing here?

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5 Answers

zenvelo's avatar

I don’t have my formulas at hand to calculate it, but if the interest rate has gone down since the bonds were bought, and you sell them now, you will lose money, your rate of return will be negative.

You have to figure out what the price paid for each of the bonds, and then calculate what the prices would be now. You have a value that will be returned at maturity ($1000) and a stream of coupons at 7%, but the increase in interest rates will reduce the current price.

frigate1985's avatar

@zenvelo Thank you. But to calculate that, would I need YTM values or Required Return Rates? The concept is a bit confusing

zenvelo's avatar

@frigate1985 You need to calculate the Present Value at the time of the first transaction, and then calculate the present value now with the higher interest rate.

frigate1985's avatar

@zenvelo ah, so I would be using the 11%, and 13% to calculate the current Bond Value right? But this actually lowers the bond value, and I thought bond value was supposed to increase until the par value (assuming that the bond price is lwoer than par value.

zenvelo's avatar

@frigate1985 Bond values go down in times of rising interest rates. There is a point where decreasing value meets the approach of maturity.

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