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When investors doubt the creditworthiness of a borrower, what should happen to the price and yield of the bond?
- Price goes down, yields go up.
- Price goes up, yields go down.
- Price goes down, yields go down.
- Price goes up, yields go up.
Relevant knowledge
The yield of bonds is the measure of an investor’s real return on an investment. If Barry purchases a 30-year saving bond through the federal government and then cash it out 30 years after, his yield will be exactly the same as the interest rate stated on the bond.
The calculation of the price of bonds is a matter of adding up the present value of the future installments of the bond. The fundamental concept behind present value is that the earlier we receive money the more valuable it will be.
The correct answer is
1, Prices go down, yield go up
The price of a bond is related to its yield. If creditworthiness is doubted, it will reduce the bond’s price and increase the yield at the same time. The following example will help you understand this relationship:
Imagine an investor buying a bond with a 10-year maturity and a coupon rate of 8% annually. The face value is $100. If interest rates rise beyond 8%, and if an investor decides not to sell the bond, it will be less attractive than other higher-interest bonds/instruments.
The price of the bond can be reduced if the owner wishes to sell it. This will allow the coupon payments and maturity values to equal the yield. Investors must also lower the price.