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Difficulty: HardDebt Securities and Bond Structure

An investor holds a corporate bond currently trading at a premium price of 1,080witha1,080 with a 50 annualcouponpayment( annual coupon payment ( 5\%nominalyield)andacallprovisionexercisableinthreeyearsatacallpriceof nominal yield) and a call provision exercisable in three years at a call price of 1,020 .Ifsecondarymarketinterestratesdeclinebyanadditional. If secondary market interest rates decline by an additional 100$ basis points, which of the following statements correctly describes the expected price behavior and yield relationships for this bond?

  1. The bond's price appreciation will be limited relative to a non-callable bond due to call risk, and its Yield to Call (YTC) will be lower than its Yield to Maturity (YTM).Answer
  2. B
    The bond's market price will drop significantly because falling market interest rates reduce the issuer's obligation to maintain high coupon interest payments.
  3. C
    The bond's Yield to Maturity (YTM) will increase above its nominal coupon rate because declining interest rates signal an expanding economic cycle that inflates yield metrics.
  4. D
    The bond's interest payments will automatically become exempt from federal income taxes because corporate bonds subject to call provisions qualify for municipal tax status.

Answer

The bond's price appreciation will be limited relative to a non-callable bond due to call risk, and its Yield to Call (YTC) will be lower than its Yield to Maturity (YTM).
For a bond trading at a premium with an active call provision, falling interest rates increase the likelihood that the issuer will call the bond to refinance at lower rates. This creates a price ceiling (call risk), capping the bond's potential price appreciation compared to a non-callable bond. Furthermore, under the yield hierarchy for bonds trading at a premium, Nominal Yield is highest, followed by Current Yield, Yield to Maturity, and Yield to Call (YTC is the lowest yield measure because the premium is amortized over a shorter period).

Step-by-Step Solution

1
Analyze the effect of declining market interest rates on existing bond prices.
Bond prices generally rise when interest rates fall due to the inverse price/yield relationship.
Existing bonds with fixed coupon payments become more valuable when prevailing yields decline.
2
Evaluate the impact of a call provision on a premium bond's price upside.
Price appreciation is capped (call risk/price ceiling) near the call price of 1,0201,020.
Investors will not pay significantly more than the call price if the issuer is expected to redeem the bond early.
3
Determine the yield hierarchy for a bond trading at a premium.
Nominal Yield > Current Yield > Yield to Maturity > Yield to Call.
For premium bonds, early call redemption accelerates the amortization of the premium paid, resulting in YTC being the lowest yield metric.

Key Concept

Callable Premium Bond Dynamics and Yield Hierarchy
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Topics

Debt Securities and Bond Structure

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