Question

Long-term Treasury bonds currently sell at yields to maturity of nearly 8%. You expect interest rates to fall. The rest of the market thinks that they will remain unchanged over the coming year.

Choose the bond that will provide the higher capital gain in each question if you are correct. Briefly explain your answer.

a. (1) A Baa-rated bond with a coupon rate of 8% and a time to maturity of 20 years.

(2) An Aaa-rated bond with a coupon rate of 8% and a time to maturity of 20 years.

b. (1) An A-rated bond with a coupon rate of 4% and maturity of 20 years, callable at

105.

(2) An A-rated bond with a coupon rate of 8% and maturity of 20 years, callable at

105.

c. (1) A 6% coupon noncallable T-bond with a maturity of 20 years and YTM 5 8%.

(2) A 9% coupon noncallable T-bond with a maturity of 20 years and YTM 5 8%.

Short answer

Answer

a. Aaa-rated bond

b.Longer coupon bond

c. Lower coupon bond

Step-by-step solution

Step by Step Solution Step 1: Evaluation of option ‘a’

The correct choice would be Aaa rated bond from option b as it has lower YTM hence the longer duration.

Evaluation of option ‘b’

The correct choice would be a lower coupon bond as it has a longer duration and more call protection.

Evaluation of option ‘c’

The correct choice would be a lower coupon bond as it has a longer duration.