Friday, March 6, 2009

Tough Question on Bond Yields

Bond yield questions can really give people fits. Let's enjoy one that draws boos and hisses from any live class I've ever taught:

One of your investing clients purchased an ABC 5% debenture yielding 6.5%. Three years later the investor sells the bond when current interest rates are at 4%. Therefore
A. I have no idea what the hell you're talking about
B. The investor broke even on the investment
C. The investor suffered a capital loss
D. The investor realized a capital gain

Obviously, we have to rule out "A," no matter how tempting. Then, we have to break down the question slowly. If you buy a bond yielding more than the nominal yield printed on the bond, that means the bond is purchased at a discount. Yields can only go up because bond prices are dropping. So, step one, the investor bought at a discount. If rates then drop below the nominal yield, the price has to rise. The investor sold at a premium. This is just a funky way of saying "bought low--sold high." The answer is "D," the investor realized a capital gain. Before working on a question, spend some time figuring out what is being asked and what is going on in the question--what is it saying? What does it mean? Interpret the "5% nominal yield purchased at a 6.5% yield" into "discount" or "bought low," and then proceed. If you're not 100% sure on the next step, you have to fall back on something like, "Well, every other time rates go DOWN, bond prices RISE, so I pretty much have to go with that."
And, you do. No brain can absorb all the information on the Series 7, not even the folks who write the questions. You have to know the vocabulary, know the fundamentals, and make up for the surprises with some really good test-taking skills.

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