Question

A company has two outstanding bond issues, both with a coupon rate of 8%. Bond A will mature in 2 years, while Bond B will mature in 15 years. If market interest rates were to increase to 10%, which of the following statements is CORRECT?

A. The company will attempt to postpone the maturity of Bond A.
B. Both bonds will be selling at a premium.
C. Bond B will be selling at a greater discount than Bond A.
D. Bond B will be selling at a greater premium than Bond A.

Answer 1

With market interest rates at 10%, higher than the 8% coupon rate, Bond B will sell at a greater discount than Bond A because longer-term bonds are more sensitive to interest rate changes, affecting their prices more significantly.

Step-by-step explanation:

If market interest rates were to increase to 10%, the correct statement is C. Bond B will be selling at a greater discount than Bond A.

When market interest rates rise above a bond's coupon rate, bonds sell at a discount because their fixed payments are less attractive compared to the new higher-yielding bonds available in the market. Since Bond A has a shorter maturity of 2 years, its price is less sensitive to changes in market interest rates (i.e., its duration is shorter), making the discount less severe compared to Bond B that will mature in 15 years.

Conversely, the longer the maturity, the more sensitive the bond price is to changes in market interest rates, causing Bond B to sell at a larger discount.