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Difficulty: EasyDebt Securities and Bond Structure

An investor holds a fixed-rate corporate bond with a par value of $1,000\$1,000 and a annual coupon rate of 5%5\%. If prevailing market interest rates decline, how does this change affect the bond's market price and its annual coupon payments?

  1. The market price increases, while the annual coupon payment remains $50\$50.Answer
  2. B
    The market price decreases, while the annual coupon payment remains $50\$50.
  3. C
    The market price increases, and the annual coupon payment increases above $50\$50.
  4. D
    The market price decreases, and the annual coupon payment decreases below $50\$50.

Answer

The market price of the bond increases, while the annual coupon payment remains fixed at 5%5\% of par value ($50\$50).
Due to the fundamental inverse relationship between interest rates and bond prices, a decrease in prevailing market interest rates causes the secondary market price of outstanding fixed-income securities to increase. Additionally, fixed-rate coupon payments are established at issuance based on the par value ($1,000×5%=$50\$1,000 \times 5\% = \$50) and remain unchanged throughout the life of the bond.

Step-by-Step Solution

1
Determine the effect of declining market interest rates on existing bond prices.
Bond prices and market interest rates share an inverse relationship. When prevailing rates drop, existing bonds with higher coupon rates become more attractive, driving their market price up.
Investors are willing to pay a premium for fixed income yielding above current market rates.
2
Determine the effect of interest rate changes on the bond's coupon payment.
The coupon payment remains exactly $50\$50 per year (5%5\% of $1,000\$1,000 par value).
A fixed-rate bond's coupon percentage is fixed upon issuance and does not change regardless of secondary market interest rate fluctuations.

Key Concept

Inverse Relationship Between Bond Prices and Interest Rates
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Topics

Debt Securities and Bond Structure

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