Question

Dillon can buy a fixed-rate bond with a 4% coupon, a $10,000 principal, and five years left to maturity or a TIPS with the same principal and age to maturity with a 2% coupon. Compare the two bonds if inflation runs 3% per year on average.

Select the best answer from the choices provided.

1The fixed-rate bond has a better yield.

2 The TIPS has a better yield.

3 Both yields are roughly equivalent.

4The yields vary with inflation.

Answer 1

Answer: 1 The fixed-rate bond has a better yield

Explanation:

a coupon rate = 4%

principal = $ 10000

x/ $10000 = 4% = 4/100

x = $400

for 5 years = $400 x 5 = $2000

with inflation of 3%

3/100 x $10000 = $300

adjusted principal = $10000 + $300 = $10300

coupon rate x adjusted principal = 4/100 x$10300 = $412per year

for 5 years = 5 x $412= $2060

b) Dillon buys buy a fixed-rate bond with a $10,000 principal

TIPS = Treasure Inflation-Protected Security rises with its principal as inflation rises = 3% per year on average

coupon rate = 2 %

without inflation = 2/100 x $10,000 = $200

with inflation upward by 3% = 3/100 x $10000 = $300

adjusted principal = $10000 + $300 = $10300

thus coupon rate x adjusted principal = 2/100 x $10300 = $206 peryear

for 5 years = 5 x $206= $1030

Therefore $2060 > $1030

The fixed bond rate has a better yield

Answer 2

3 Both yields are roughly equivalent.