Confused on bond pricing question
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Do I assume that facevalue is $100 and then find the PV or would it be better to work out IRR with $100fv
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Assume the price is 100.
Bond A: you receive the $100 at maturity, and $5 a year for 3 years. So that's $115 in total. Subtract the 90 you paid, and that's $25 profit.
Bond B: you recieve the $100 at maturity, and $6 a year for 5 years. So that's $130 in total. Subtract the 88 you paid, and that's $42 profit.
So Bond B is better.
Bond B costs less and pays more interest, but lasts longer. The IRRs are actually very similar (8.87% for Bond A, vs. 9.04% for Bond B, using semi-annual coupon payments, you can calc it in Excel or on an HP12C and discount the cashflows every period to double check that the sum of cash flows will equal the bond price once discounted by the IRR).
Some qualitative thoughts which I think are more important than the IRR calc:
Qualitatively you really have to evaluate whether you would rather wait two more years to get Bond B back
It depends on what you think will happen to rates and how you could reinvest your money in Year 3 if you invested in Bond A and got the principal back
Shape of yield curve and expected change in that matters, as well as opportunity cost (can you invest in something else at the same 3 or 5 year tenure and get something better?) There is usually a reason why a bond price is lower whether credit quality or rate expectations, etc. so that should be investigated.
The riskiness of the investment also matters quite a lot - are they the same issuer? If Bond B is not federally guaranteed and is a corporate bond, is it worth it to take the extra 2 years repayment risk?
It also depends on whether you would prefer to lock in a longer tenure to match assets & liabilities
Finally I guess this is a more minor consideration but taxes / timing of cash flows may also play into a decision, amortization of OID, etc.
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