Final answer:
The yield to maturity on Bond A is a reflection of the total return an investor will receive if holding the bond until maturity, considering factors like interest rates and risk. If interest rates rise, the bond's price may drop to attract buyers, leading to a higher yield to maturity when purchased at a discount.
Step-by-step explanation:
The yield to maturity on Bond A is the percentage rate of return for the bond if it is held until its maturity date. When considering the risk of a bond and the surrounding economic conditions, such as prevailing interest rates, the price of a bond can fluctuate to become more or less attractive to investors.
If interest rates rise, the price of an existing bond with a lower yield may decrease, as newer bonds offer higher returns. Let's explore the scenario provided:
If a bond was issued at a $1,000 value with an 8% coupon rate, it would normally pay $80 per year. However, with interest rates rising to 12%, and only one year left to maturity, the bond at 8% is less appealing. Thus, the seller would need to reduce the price below the face value to make it attractive to buyers.
Calculating the bond yield in light of these conditions involves comparing the bond's adjusted price to its face value and coupon rate. If we expect to pay less than the face value due to the increase in interest rates, the yield to maturity will be higher than the original coupon rate because the investor is buying the bond at a discount and will still receive the face value at maturity.