Final answer:
The rate of return on each bond includes the coupon payment and any capital gains or losses from selling the bond at the current yield to maturity. The rate of return is calculated by adding the annual coupon payment to the price change and dividing by the initial bond price. Yield to maturity plays a significant role in the bond's selling price.
Step-by-step explanation:
The student has asked about the rate of return on two different bonds with specific coupon rates, given that both bonds pay interest annually, have 6-year maturities, and sell at a yield to maturity of 7.0%. If yields to maturity remain at 7.0% next year, the return on each bond would include both the coupon payment and any capital gain or loss if the bond is sold before maturity.
To determine the rate of return on each bond, one would calculate the total income received (which is the coupon payment) plus the change in the price of the bond if it is sold one year from now at the same yield to maturity. The formula for the rate of return is as follows: Rate of Return = (Coupon Payment + Price Change) / Initial Bond Price.
For example, if a bond with a coupon rate of 5.6% has a face value of $1,000, the annual coupon payment would be $56. If this bond is purchased at par (face value) and sold a year later when the yield to maturity is still 7.0%, it will be sold at a price reflecting that yield. The rate of return would thus be the coupon payment of $56 plus any capital gain or loss from selling the bond at a price consistent with a 7.0% yield to maturity.
Similarly, a second bond with a coupon rate of 8.3% and the same conditions will have a higher coupon payment of $83 annually. The rate of return will also combine this payment with any capital gain or loss from the sale of the bond.
It's important to remember that the yield to maturity is a critical factor in pricing bonds when sold on the market before they reach maturity.