I just received a good, tough Series 7 practice question from a customer. She must be using a different company's questions, but this one is worth looking at in some detail:
QUESTION:
An investor bought 6% and 7% 15-year municipal bonds at a 5.50 basis. Which bond will have the greatest price appreciation if the market moves to 85.40?
a. 6% bond
b. 7% bond
c. both will appreciate equally
d. neither, since the market moved down
Answer is d. my question is how do we know that 85.40 means the market moved down?
RESPONSE:
Denise, thanks for sending in this question--not sure who wrote it, but it's about as tricky as it can possibly be. To ask about "the greatest price appreciation," when, in fact, the market price dropped is pretty evil. How do we know that "85.40 means the market moved down?" We have to use reasoning skills. If the coupon/nominal yield on a bond is 6% or 7% when the investor bought it at a yield/basis of just 5.50%, that is a premium bond. Right? If the yield is lower than the nominal/coupon rate, the price is above par. The question then gives you a market price well below par--$854.00. So, the market prices went from above par (premium) to below par (trading at a discount).
Wow. Not sure the actual test will be this evil, but I'm glad somebody's preparing you for even the most evil approach to a tough concept.
Then, which is better from the investor's perspective, purchasing a bond at a Discount or a Premium? Discount, right? That means we paid less and will hopefully get more... but doesn't that mean a higher Yield which is Junk?
ReplyDeleteBonds trade at discounts and premiums largely due to current interst rates. So, a bond trading for $960 might simply reflect that interest rates rose compared to the coupon rate named on the bond when it was issued.
ReplyDeleteOn the other hand, a bond trading at $600 is not down there because of interest rates, most likely. It's been downgraded by Moody's and S & P, and is considered "high-yield" or "junk."
Do investors want high yields?
Absolutely. But, they don't like defaults. Oh well--they can't have it both ways. If you want a high yield, you take on default risk. If you insist on the safety of US Treasuries, you get a low yield.
If you buy a junk bond for $600, yes, you get a huge yield, but what if the issuer then declares a default--no more interest payments, and in bankruptcy you might get $80-100 per bond?
Ouch.
So, chasing after high-yield/junk bonds involves more credit/default risk. In the 1980's, a famous junk bond salesman preached that investors would always come out ahead with junk bonds, even with the more frequent defaults. As we saw with mortgage-based deriviatives, almost anything can be believed on Wall Street until disaster strikes.
Again, an investor doesn't say, "I want to buy a discount bond--no, make it a premium." He or she simply has an investment objective and a risk tolerance level. If interest rates are low, as they are now, conservative investors simply won't get high yields. Junk bond investors right now can get MUCH higher yields (the yield spread is wide right now) as compared to the yield on US Treasuries, but with the credit markets as crazy as they've been, can you afford to put your money into shaky issuers? How about your clients' money?
If interest rates are higher in a few years, bond yields will be higher (by definition), and fixed-income investors will be receiving higher yields (existing bonds will trade at a discount). So, bonds trade at discounts and premiums simply to create yields in line with current interest rates. If your bond says 6% on it when new bonds only offer 3%, I have to pay you more $ to push the yield down to the 3% level. It's not about whether I "want to pay a premium." It's about the fact that interest rates/yields are around 3% for a bond of this particular term to maturity and credit quality. I can get 3% on a newly issued bond coming to the primary market, or I can get 3% from you on the secondary market--we turn your 6% nominal yield into my 3% yield to maturity when I pay the premium, you walk away with a capital gain, and I go forward with a 3% yield to maturity.