7-12 YIELD TO CALL It is now January 1, 2011, and you are considering the purcha

Question

7-12 YIELD TO CALL It is now January 1, 2011, and you are considering the purchase of an outstanding bond that was issued on January 1,2009. It has a 9.5% annual coupon and had a 30-year original maturity. (It matures on December 31, 2038.) There is 5 years of call protection (until December 31, 2013), after which time it can be called at 109-that is, at 109% of par, or $1,090. Interest rates have declined since it was issued; and it is now sellin at 116.575% of par, or $1,165.75. b. If you bought this bond, which return would you actually earn? Explain your reasoning Suppose the bond had been selling at a discount rather than a premium. Would the yield to maturity have been the most likely return, or would the yield to call have been most likely? c.

Explanation / Answer

b) As the interest rates have declined and yield to call is lower than yield to maturity, the bonds are likely to be called. Hence, you would earn yield to call.

c) If the bond is selling at a discount, it means that the interest rates have risen. As a result, the yield to call is likely to be higher than yield to maturity and so, the bonds are unlikely to be called. Hence, you would most likely earn yield to maturity.

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