Chartered Financial Analyst (CFA) Practice Exam Level 2

What occurs to bond values as they approach maturity when riding the yield curve?

1. They are valued using successively higher yields

2. They are valued using fixed yields

3. They are valued using successively lower yields

4. They are not impacted by time left to maturity

The correct answer is: They are valued using successively lower yields

As bonds approach maturity while riding the yield curve, their values generally reflect successively lower yields. This phenomenon occurs due to the relationship between bond prices and yields: as a bond approaches its maturity date, the uncertainty surrounding its cash flow diminishes, and the bond's price converges to its face value. The yield curve usually slopes upward, indicating that longer-term bonds typically have higher yields than shorter-term bonds. As a bond nears its maturity, investors demand a lower yield because they are closer to receiving the principal back, resulting in an increase in the bond's price if the yield decreases. Thus, bonds are valued using successively lower yields as they get closer to their maturity date, reflecting the decreasing risk associated with those cash flows. Additionally, this dynamic indicates that, as yields on newly issued bonds might fluctuate, the market value of existing bonds will adjust to align with the current prevailing interest rates, which tend to be lower for shorter maturities in an upward-sloping yield curve.