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Difficulty: MediumDebt Securities and Bond Structure

An investor holds a 6%6\% fixed-rate corporate bond with 10 years remaining until maturity. If prevailing market interest rates increase by 100 basis points, which of the following statements accurately describes the effect on the bond's market price and nominal yield?

  1. The market price of the bond decreases, while its nominal yield remains unchanged at 6%6\%.Answer
  2. B
    The market price of the bond increases, while its nominal yield decreases below 6%6\%.
  3. C
    The market price of the bond remains unchanged, while its nominal yield increases to match prevailing rates.
  4. D
    The market price of the bond decreases, and its interest income becomes exempt from state income tax.

Answer

The market price of the bond decreases, while its nominal yield remains unchanged at 6%6\%.
Fixed-income securities experience an inverse relationship between prevailing interest rates and market price. When market interest rates rise, existing fixed-rate bonds must trade at a discount to yield competitive returns to new buyers. However, the nominal yield (the stated annual coupon rate) is established in the bond's indenture at issuance and never changes over the life of the security.

Step-by-Step Solution

1
Analyze the relationship between market interest rates and secondary market bond prices.
When market interest rates rise, existing bonds paying lower relative coupons become less attractive, causing their market prices to fall.
Bond prices and market yields share an inverse economic relationship.
2
Evaluate the stability of the bond's nominal yield.
The nominal yield (coupon rate) is contractual and fixed based on the par value (1,0001,000). It remains 6%6\% regardless of secondary market price changes.
Stated annual coupon payments do not adjust after issuance for standard fixed-rate corporate bonds.

Key Concept

Inverse Price/Yield Relationship and Fixed Nominal Yield
Estimated Time:1m 15s
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Topics

Debt Securities and Bond Structure

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