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Difficulty: MediumDebt Securities and Bond Structure

An investor purchases a 1,000parvaluecorporatebondtradingatamarketpriceof1,000 par value corporate bond trading at a market price of 1,120. The bond pays a 5% annual coupon and has 10 years remaining until maturity. Which of the following statements correctly describes the relationship among the bond's yields?

  1. Yield to maturity is lower than the current yield, which is lower than the nominal yield.Answer
  2. B
    Nominal yield is lower than the current yield, which is lower than the yield to maturity.
  3. C
    Yield to maturity and current yield are both equal to the nominal yield.
  4. D
    Current yield is higher than the nominal yield, but lower than the yield to call.

Answer

Yield to maturity is lower than the current yield, which is lower than the nominal yield.
When a bond is purchased at a premium (above par value), the investor pays more upfront than the principal returned at maturity. This reduces the total rate of return below the annual coupon rate. Consequently, the yield hierarchy for a premium bond from highest to lowest is Nominal Yield > Current Yield > Yield to Maturity.

Step-by-Step Solution

1
Determine whether the bond is trading at a discount, par, or premium.
The bond's market price (1,120)ishigherthanitsparvalue(1,120) is higher than its par value ( 1,000), meaning the bond trades at a premium.
Identifying the price status relative to par establishes the directional ordering of yields.
2
Apply the yield hierarchy rule for premium bonds.
For premium bonds, the yields rank in the order of Nominal Yield > Current Yield > Yield to Maturity > Yield to Call.
An investor paying more than face value receives less overall yield than the stated coupon because the $120 premium represents a capital loss realized by maturity.

Key Concept

Yield Hierarchy for Premium Debt Securities
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Topics

Debt Securities and Bond Structure

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