Bond Price and Yield Changes: 10-Year 5% Treasury Bond | CFA Level 1 Exam

B

To answer this question, let's analyze the given information step by step.

We are told that a 10-year Treasury bond is issued at a price to yield 5.2%. This means that when the bond was initially issued, the prevailing market interest rates were higher than the coupon rate of the bond. Consequently, investors would demand a discount on the bond's price to compensate for the lower coupon payments compared to the prevailing market rates.

Since the bond is issued at a price to yield 5.2%, it implies that the bond was issued at a price below its par value. A yield higher than the coupon rate indicates that the bond is selling at a discount.

Now, three months after issuance, market rates for 10-year Treasuries decline by 100 basis points. This means that the prevailing market interest rates have decreased by 1%. When market rates decline, the prices of existing bonds generally increase because their fixed coupon payments become more attractive compared to newly issued bonds with lower coupon rates.

As a result of the decline in market rates, the price of the 10-year Treasury bond will likely rise. When bond prices increase, their yields decrease. Therefore, after three months, the bond's yield would likely be lower than the initial 5.2% yield at issuance.

Now, let's consider the given answer choices:

A. Above par at issuance, but below par three months later: This choice suggests that the bond was initially issued at a price above its par value, but after three months, its price decreases and falls below par. However, since the bond was issued at a price below par (as explained earlier), this choice is incorrect.

B. Below par at issuance, but above par three months later: This choice suggests that the bond was issued at a price below par (which is correct) and after three months, its price increases and goes above par. This is the most likely scenario given the information provided, as declining market rates generally lead to an increase in bond prices. Therefore, this choice is the most accurate answer.

C. Below par at issuance, and below par three months later: This choice suggests that the bond was issued at a price below par (which is correct), and after three months, its price remains below par. However, based on the explanation above, it is more likely that the bond's price would increase after three months due to the decline in market rates. Therefore, this choice is not the most likely outcome.

In conclusion, the most likely price of the bond is below par at issuance and above par three months later, so the correct answer is B. below par at issuance, but above par three months later.