Question

Tom purchased a bond today with a 20-year maturity and a yield to maturity (YTM) of 6%. The coupon rate is 8% and coupons are paid annually. The par value is $1,000. Tom is going to hold this bond for 3 years and sell the bond at the end of year 3. The bond's yield to maturity will change to 8% at the time when Tom sells the bond. Assume coupons can be reinvested in short term securities over the next three years at an annual rate of 10%. Which of the following regarding Tom’s annual holding period return (HPR) of this bond investment is correct?

I. Tom’s annual HPR will be higher than 6% due to a capital gain from selling the bond at year 3
II. Tom’s annual HPR will be lower than 6% due to a capital loss from selling the bond at year 3
III. Tom’s annual HPR will be higher than 6% due to the higher reinvestment rate of 10%
IV. Tom’s annual HPR will be lower than 6% because gains from the 10% reinvestment rate will be largely offset by the capital loss from selling the bond at year 3

a. I only
b. II only
c. III only
d. I and III only
e. II and IV only

Answer 1

The answer happens to be:

e. II and IV only

II. Tom’s annual HPR will be lower than 6% due to a capital loss from selling the bond at year 3

IV. Tom’s annual HPR will be lower than 6% because gains from the 10% reinvestment rate will be largely offset by the capital loss from selling the bond at year 3

Step-by-step explanation: