The current yield tends to overstate a bond's total return when the bond sells for a premium because:Select one:a.the bond's price will decline each year.b.coupon payments can change at any time.c.bonds selling for a premium have low default risk.d.taxes must be paid on the current yield.
Question
The current yield tends to overstate a bond's total return when the bond sells for a premium because:Select one:a.the bond's price will decline each year.b.coupon payments can change at any time.c.bonds selling for a premium have low default risk.d.taxes must be paid on the current yield.
Solution
The answer is a. the bond's price will decline each year.
Here's why:
The current yield of a bond is calculated by dividing the annual coupon payment by the bond's current market price. It does not take into account any capital gains or losses the investor will realize if they hold the bond until maturity.
When a bond sells for a premium (i.e., its market price is higher than its par value), its price will gradually decline towards its par value as it approaches its maturity date. This is because at maturity, the bondholder will only receive the par value of the bond, not its premium price.
Therefore, the current yield, which only considers the annual coupon payment and not the capital loss due to the price decline, tends to overstate the bond's total return when the bond sells for a premium.
Similar Questions
Bond A is currently selling at par and has a yield of 5%. Bond B has the same coupon rate as A but is selling at a premium. Given this information, which of the following statements is correct. Bond B's coupon rate is below 5%. Bond B's coupon rate is above 5%. Bond B's yield is below 5%. Bond B's yield is above 5%.
Which of the following is correct for a bond investor whose bond offers a 5% current yield and an 8% yield to maturity?Select one:a.The bond is selling at a discount to par value.b.The bond has a high default premium.c.The promised yield is not likely to materialize.d.The bond must be a Treasury Inflation-Protected Security.
Bond A has a coupon rate of 5% and a yield of 3.5%. It is currently selling on the market for less than its face value. From this you know:Bond A has a high credit rating. Bond A is in default. Bond A is overvalued on the market. Bond A is undervalued on the market.
Once a bond defaults, bondholders can no longer receive any residual payment from the bond.Corporate bond yields are generally lower than government bond yields for bonds having the same coupon rate and maturity.The spread of junk bond yields over that of Australian Government Bond is generally lower than the spread of investment-grade bonds over that of the Australian Government Bond.Two bonds have the same maturity, risk rating, and face value, but have different coupon rates. The bond with a lower coupon rate carries greater risks.
A bond that is held to maturity A. will necessarily have a yield to maturity equal to the coupon rate. B. will necessarily earn the yield to maturity at the time of purchase. C. may earn more or less that its yield to maturity at the time of purchase because the rate at which coupons can be reinvested may change. D. will earn the yield to maturity at the date of maturity.
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