An investor is considering one of the newly issued 10 year AAA corporate bonds s
ID: 2761803 • Letter: A
Question
An investor is considering one of the newly issued 10 year AAA corporate bonds shown in the following table:
Description
Coupon
Price
Callable
Call Price
XYZ
6.00%
100
Non-callable
N/A
RST
6.20%
100
Currently Callable
102
A. Suppose that market interest rates decline by 100 basis points (1%). Contrast the effect of this decline on the price of each bond.
B. Should the investor prefer the RST bond to the XYZ bond when rates are expected to rise or to fall?
C. What would be the effect, if any, of an increase in the volatility of interest rates on the prices of each bond?
Description
Coupon
Price
Callable
Call Price
XYZ
6.00%
100
Non-callable
N/A
RST
6.20%
100
Currently Callable
102
Explanation / Answer
A. When the market interest rates decline by 100 basis points, the price of the bonds in the market rise, thereby leading to a lower yield.
B. RST bonds are preferred bonds as they are at a higher coupon and are callable. In general because investors take a greater risk by purchasing callable bonds, they usually get higher yields to compensate. This means that the bond pays a higher interest rate if it is callable than if it is noncallable.
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