Which of the following statements is correct? a. Bonds are riskier than common stocks and have higher required returns, as a result. b. The market value of a bond will always approach its par value as its maturity date approaches, provided bond’s yield remains constant. c. If the federal reserve unexpectedly announces that it expects inflation to increase, then we would probably observe an immediate increase in bond prices. d. If the federal reserve unexpectedly announces that it expects inflation to increase, then we would probably observe an immediate increase in bond prices.
The correct answer and explanation is:
The correct answer is b. The market value of a bond will always approach its par value as its maturity date approaches, provided the bond’s yield remains constant.
Explanation:
- Option a is incorrect because bonds are generally considered less risky than common stocks. Bonds represent debt, and bondholders are paid before stockholders in the event of liquidation. Common stocks represent equity, and their value can fluctuate significantly, which typically makes them riskier than bonds. As a result, the required return (or yield) on common stocks is usually higher than that on bonds.
- Option b is correct. The market value of a bond tends to move toward its par value as the maturity date approaches, assuming the yield (interest rates) remains constant. This is due to the principle of bond pricing. If a bond is purchased at a premium (above its par value), it will gradually decrease in value as it approaches maturity, and similarly, if it was purchased at a discount (below its par value), it will increase in value. This convergence happens because the bond’s coupon payments and its face value become the primary considerations as maturity nears.
- Option c is incorrect because if the Federal Reserve expects inflation to increase, bond prices typically fall, not rise. Inflation erodes the purchasing power of fixed interest payments on bonds, making them less attractive. To compensate for the anticipated inflation, bond yields will rise, and consequently, the bond prices will decrease. This is a standard reaction to inflationary expectations.
- Option d is a repeat of Option c, so the explanation remains the same. An increase in expected inflation leads to higher interest rates, which generally causes bond prices to fall.
Thus, the market value of a bond approaching its par value as maturity nears is a key principle of bond pricing under stable interest rate conditions.