Question

Bonds of Zello Corporation with a par value of \(1,000 sell for \)960, mature in five years, and have a 7% annual coupon rate paid semi-annually.

a. Calculate the:

(1) Current yield.

(2) Yield to maturity.

(3) Horizon yield (also called realized compound return) for an investor with a three year holding period and a reinvestment rate of 6% over the period. At the end of three years the 7% coupon bonds with two years remaining will sell to yield 7%.

b. Cite one major shortcoming for each of the following fixed-income yield measures:

(1) Current yield.

(2) Yield to maturity.

(3) Horizon yield (also called realized compound return).

Short answer

a. 7.29%.

b. (i) Doesn’t account for capital gains or losses

(ii) Assumes that the bond is held until maturity

(iii) Affected by the rates forecasts

Step-by-step solution

Calculation of current yield ‘a’

(i) Current yield = Coupon Price

= $70 / $960 = 0.0729

= 7.29%

Explanation of shortcoming ‘b’

(i) Current yield – It doesn’t account for capital gains or losses on bonds or for reinvestment income on coupon payments.

(ii) Yield to Maturity – It assumes that the bond is held until maturity which can be reinvested at a rate equal to YTM

(iii) Realized compound yield – It is affected by the rates forecasts.