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Difficulty: EasyGovernment, Municipal, and Corporate Bonds

When market interest rates rise, which of the following best describes the effect on the market price and current yield of an existing fixed-rate corporate bond trading in the secondary market?

  1. The bond's market price decreases, and its current yield increases.Answer
  2. B
    The bond's market price increases, and its current yield decreases.
  3. C
    Both the bond's market price and its current yield increase.
  4. D
    The bond's market price remains unchanged, but its stated coupon rate increases.

Answer

The bond's market price decreases, and its current yield increases.
Fixed-income securities exhibit an inverse relationship between market interest rates and secondary market bond prices. When interest rates rise, newly issued bonds offer higher yields, causing existing bonds with lower coupon rates to drop in market price. Because current yield is calculated as annual interest divided by market price, the reduction in market price results in a higher current yield.

Step-by-Step Solution

1
Analyze the relationship between prevailing market interest rates and secondary market bond prices.
Bond prices and interest rates share an inverse relationship. When prevailing market rates rise, existing bonds with lower fixed coupon rates become less attractive, driving their market price down.
Investors demand competitive yields, forcing older, lower-coupon bonds to trade at a discount.
2
Evaluate the formula for current yield: Current Yield=Annual Coupon InterestCurrent Market Price\text{Current Yield} = \frac{\text{Annual Coupon Interest}}{\text{Current Market Price}}.
Since the annual coupon interest payment is fixed, a decrease in the denominator (market price) causes the overall current yield quotient to increase.
Yield moves inversely to price.

Key Concept

Inverse Relationship Between Bond Prices and Interest Rates
Estimated Time:45s
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Topics

Government, Municipal, and Corporate Bonds

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