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Difficulty: HardDebt Securities and Bond Structure

An institutional investor is evaluating two corporate bonds issued by the same corporation with identical maturity dates and credit ratings. Bond A is a 6%6\% annual coupon bond currently trading at a premium (108%108\% of par), while Bond B is a zero-coupon bond trading at a deep discount. If prevailing market interest rates increase by 100100 basis points across all maturities, which of the following best describes the relative price sensitivity and yield behavior of these two securities?

  1. Bond B will experience a greater percentage price decline than Bond A, while the yield to maturity on both bonds will rise to reflect market rates.Answer
  2. B
    Bond A will increase in market price due to its higher coupon rate remaining attractive, whereas Bond B will decrease in market price.
  3. C
    Both bonds will experience identical percentage price declines because interest rate risk depends exclusively on issuer credit rating and maturity date.
  4. D
    Bond A will experience a greater percentage price decline than Bond B because premium bonds face severe price volatility when yield curves invert during economic expansions.

Answer

Bond B will experience a greater percentage price decline than Bond A, while the yield to maturity on both bonds will rise to reflect market rates.
When market interest rates rise, secondary market bond prices fall. Zero-coupon bonds have longer duration than coupon-paying bonds of equal maturity because no cash flows are received until maturity. Consequently, the zero-coupon bond experiences a sharper percentage price decrease than the premium coupon bond, while the yield to maturity on both instruments increases to align with higher prevailing yields.

Step-by-Step Solution

1
Analyze the inverse relationship between interest rates and bond prices
When market interest rates increase by 100100 basis points, the prices of existing fixed-rate bonds decline so their yields remain competitive.
Bond prices and interest rates always move in opposite directions in secondary markets.
2
Compare duration and price volatility of coupon bonds versus zero-coupon bonds
Bond B (zero-coupon) has a higher duration than Bond A (6%6\% coupon) because all cash flow for Bond B is deferred until maturity.
Lower or zero coupon rates increase effective duration, causing larger percentage price changes for a given change in interest rates.
3
Determine the impact on yields to maturity (YTM)
The YTM for both securities rises to match market yield demands.
Yields adjust upward through secondary market price decreases.

Key Concept

Bond Duration and Price Sensitivity to Interest Rate Changes
Estimated Time:2m 0s
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Topics

Debt Securities and Bond Structure

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