Final answer:
The current yield on ND Electric Company bonds is 5.3%. Bond pricing is inversely related to changes in interest rates, which is why the bond is currently trading at a premium because of a drop in market interest rates compared to the coupon rate.
Step-by-step explanation:
To calculate the current yield on ND Electric Company bonds, we use the formula for current yield which is:
Current Yield = (Annual Coupon Payment / Market Price) × 100%
In this case, we have an annual coupon rate of 6.5% on a $1,000 bond, which gives us an annual coupon payment of:
$1,000 × 0.065 = $65
The bond's current market value is $1,225. Plugging these numbers into the formula gives us:
Current Yield = ($65 / $1,225) × 100% ≈ 5.3%
The correct answer to the student's question is option c, 5.3%.
Bond pricing is inversely related to changes in interest rates. If interest rates rise, new bonds are issued at those higher rates, which makes existing bonds with lower rates less attractive. As a result, those bonds will typically sell for less than their face value (a discount). Conversely, when interest rates fall, existing bonds with higher rates than the current market become more attractive, leading to those bonds selling for more than their face value (a premium).
Regarding the local water company's bond with a face value of $10,000 and a coupon rate of 6%, if current interest rates rise to 9%, one would expect that the bond would sell for less than $10,000 because of the less competitive coupon rate.