QUESTION TWO

Last year, the yield on AAA-rated corporate bonds averaged approximately 5 per cent; one

year later, the yield on these same bonds had climbed to about 6 per cent because the

Reserve Bank of Australia increased interest rates during the year. Assume that Boral Limited

issued a 10-year, 5 per cent coupon bond one year ago (on the 1

st

of January). On the same

date, Argo Limited issued a 20-year, 5 per cent coupon bond. Both bonds pay interest

annually.

Assume that the market rate on similar risk bonds was 5 per cent at the time 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 were 6 per cent.

c. Compute the capital gains yield for each bond during the year.

d. Compute the current yield for each bond during the year.

e. Compute the total return that each bond would have generated for investors during

the year.

f. If you invested in bonds at the beginning of the year (one year ago on the 1

st

of January), would you have been better off if you held long-term or short-term

bonds? Explain.

g. Assume that interest rates stabilise at rate of 6 per cent, and then they stay at this

level indefinitely. What would be the price of each bond after six years had passed?

Describe what should happen to the prices of these bonds as they approach their

maturities.