In January 2011, the yield on AAA-rated corporate bonds averaged approximately 5 percent; suppose one year later, the yield on these same bonds had climbed to about 6 percent because the Federal Reserve increased interest rates during the year. Assume that IBM issued a 10-year, 5 percent coupon bond on January 2, 2011. On the same date, Microsoft issued a 20-year, 5 percent coupon bond. Both bonds pay interest annually. Also assume that the market rate on similar-risk bonds was 5 percent at the time that the bonds were issued.
a. Compute the market value of each bond at the time of issue.
b. Compute the market value of each bond one year after issue if the market yield for similar risk bonds was 6 percent on January 1, 2012.
c. Compute the 2011 capital gains yield for each bond.
d. Compute the current yield for each bond in 2011.
e. Compute the total return that each bond would have generated for investors in 2011.
f. If you invested in bonds at the beginning of 2011, would you have been better off if you held long-term or short-term bonds? Explain.
g. Assume that interest rates stabilize at the January 2011 rate of 6 percent, then they stay at this level indefinitely. What would be the price of each bond on January 1, 2017, after six years have passed? Describe what should happen to the prices of these bonds as they approach their maturities.