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Difficulty: MediumDebt Securities and Bond Structure

An investor purchases a 5%5\% corporate bond with a par value of $1,000\$1,000 at a current market price of $800\$800. What is the current yield of this bond?

  1. 6.25%6.25\%Answer
  2. B
    5.00%5.00\%
  3. C
    4.00%4.00\%
  4. D
    3.125%3.125\%

Answer

The current yield of the bond is 6.25%6.25\%.
The correct answer is 6.25%6.25\%. The current yield formula is defined as Current Yield=Annual Coupon PaymentCurrent Market Price\text{Current Yield} = \frac{\text{Annual Coupon Payment}}{\text{Current Market Price}}. Calculating 5%5\% of $1,000\$1,000 yields an annual payment of $50\$50. Dividing $50\$50 by the discounted purchase price of $800\$800 results in 6.25%6.25\%. When a bond trades at a discount, its current yield is always higher than its nominal yield.

Step-by-Step Solution

1
Calculate the annual coupon interest payment in dollars.
Annual Coupon Payment=5%×$1,000=$50\text{Annual Coupon Payment} = 5\% \times \$1,000 = \$50
Bond interest payments are fixed percentage rates of par value ($1,000).
2
Apply the current yield formula.
Current Yield=Annual InterestCurrent Market Price=$50$800=0.0625=6.25%\text{Current Yield} = \frac{\text{Annual Interest}}{\text{Current Market Price}} = \frac{\$50}{\$800} = 0.0625 = 6.25\%
Current yield measures the return provided by annual coupon payments relative to the actual price paid in the secondary market.

Key Concept

Current Yield Calculation for Debt Securities
Estimated Time:1m 0s
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Topics

Debt Securities and Bond Structure

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