Question

Company A has issued a bond with a face value of $1,000 and a coupon rate of 5%. The bond matures in 5 years and has a yield to maturity of 6%.

a. What is the coupon rate of a bond?
b. What is the annual interest payment for the bond?
c. What is the market price of the bond?
d. What is the current yield of the bond?

Answer 1

The bond's coupon rate is the annual interest rate paid to bondholders, and for the given company, it's fixed at 5%. The annual interest payment would be $50 for the bond described. Market price and current yield depend on the yield to maturity and current market rates, with the bond's price expected to be below its face value due to a YTM higher than the coupon rate.

Step-by-step explanation:

Understanding Bond Terms and Valuation

A bond represents an 'I owe you' from the issuer to the investor and includes several key features:

• The face value is the principal amount the issuer will pay the investor upon maturity.
• The coupon rate is the interest rate paid on the bond, usually on an annual or semi-annual basis.
• The maturity date is when the bond will be repaid in full.
• The bond's yield to maturity (YTM) reflects the total return expected on the bond if held to maturity, accounting for both the interest payments and any capital gains or losses.
• Market price of the bond can fluctuate based on current market interest rates.

For the specific question:

1. The coupon rate is the interest rate the company pays on the borrowed funds, which is 5% in this scenario.
2. The annual interest payment is the dollar amount paid each year on the bond's face value. With a 5% coupon rate on a $1,000 bond, the annual interest payment is $50.
3. The market price of the bond will be less than the face value because its YTM of 6% is higher than the coupon rate of 5%. The exact market price would require a calculation using a bond pricing formula or financial calculator.
4. The current yield is calculated by dividing the annual interest payment by the bond's market price. It will be higher than the coupon rate if the market price is below the face value due to the yield to maturity being higher.

When market interest rates rise, existing bonds with lower interest rates become less desirable, causing their market prices to decrease. Conversely, when market rates fall, those same bonds become more valuable, increasing their market price.