Question 1

What is the difference between current yield and yield to maturity?

Accepted Answer

Current yield only considers the annual coupon payment relative to the current price, ignoring any capital gain or loss at maturity. Yield to maturity (YTM) is more comprehensive: it includes coupon income plus the amortized gain or loss from buying below or above par value, annualized over the remaining life of the bond. YTM is the better measure for comparing bonds because it accounts for total expected return.

Question 2

Why do bond prices and yields move in opposite directions?

Accepted Answer

When market interest rates rise, newly issued bonds offer higher coupons, making existing bonds with lower coupons less attractive. Their prices drop to compensate, raising their effective yield to match market rates. Conversely, when rates fall, existing bonds with higher coupons become more valuable, pushing prices up and yields down. This inverse relationship is fundamental to fixed income investing.

Question 3

What does it mean when a bond trades at a premium or discount?

Accepted Answer

A bond trades at a premium when its price is above face value (e.g., $1,050 on a $1,000 bond), which happens when the coupon rate exceeds current market rates. It trades at a discount when the price is below face value (e.g., $950), which occurs when the coupon rate is below market rates. At maturity, the bond pays face value regardless of what you paid, so premium bonds lose value and discount bonds gain value over time.

Question 4

Are bonds safer than stocks?

Accepted Answer

Bonds are generally less volatile than stocks, especially high-quality government and investment-grade corporate bonds. However, they are not risk-free. Bond investors face interest rate risk (price drops when rates rise), credit risk (issuer may default), inflation risk (returns may not keep pace with inflation), and reinvestment risk. Government bonds are backed by the full faith of the U.S. government, making default risk negligible, but other risks still apply.

Question 5

What is the approximate YTM formula?

Accepted Answer

The approximate YTM formula is: YTM = (C + (F-P)/n) / ((F+P)/2), where C is the annual coupon payment, F is the face value, P is the current price, and n is years to maturity. This provides a close estimate of the true YTM, which technically requires solving for the internal rate of return using iterative methods. The approximation is typically within 0.1-0.2 percentage points of the exact calculation.

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