Is it true? Please, explain in a very accurate and detailed way, provide logical

Question

Is it true? Please, explain in a very accurate and detailed way, provide logical and consistent answer. It is very important in this task. Provide VERY DETAILED explanation.

A bond that is callable has a chance of being retired earlier than it started turn to maturity. Therefore, if the yield curve is upward sloping, an outstanding callable bond should have a lower yield to maturity than an otherwise identical noncallable bond?

Please, note that every calculation should be supported with formulas and excel is prohibited so everything should be done by hand.

Explanation / Answer

FALSE.

The buyer should be rewarded for accepting the risk of having to reinvest the proceeds from a call of the bond at what would be lower interest rate due to the yield curve. As one site explains:

"Yields on callable bonds tend to be higher than yields on noncallable, “bullet maturity” bonds because the investor must be rewarded for taking the risk the issuer will call the bond if interest rates decline, forcing the investor to reinvest the proceeds at lower yields.

With a callable security, the investor’s compensation for selling the option is reflected in a higher yield and lower price as compared to a similar bullet security with the same maturity. In an example from 1997, A U.S. agency was offered at a yield of 6.856 percent while a 10-year bullet with the same coupon carried a yield of 6.236 percent. The difference in dollar price between these two securities would represent the value of the call option.

The investor has to determine the value of the option and the level of compensation required for the associated risks in a callable security."

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