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Difficulty: Very hardDebt Securities and Bond Structure

An investor holds a 1010-year corporate bond with a 6.5%6.5\% annual coupon rate trading in the secondary market at a premium price of $1,080\$1,080. The bond features a call provision allowing the issuer to redeem the bond in 33 years at par value ($1,000\$1,000). Which of the following statements correctly describes the relationship between the bond's Yield to Call (YTC) and its Current Yield (CY), along with the accurate financial reasoning behind that relationship?

  1. The Yield to Call is lower than the Current Yield because the premium loss of $80\$80 is accelerated over a shorter 33-year period rather than spread over the full 1010-year maturity.Answer
  2. B
    The Yield to Call is higher than the Current Yield because receiving the principal return early increases the investor's effective annual compounding rate.
  3. C
    The Yield to Call is equal to the Current Yield because call provisions only affect nominal yield calculations when benchmark interest rate curves invert.
  4. D
    The Yield to Call is lower than the Current Yield solely because early call redemption subjects the investor to default risk adjustments.

Answer

The Yield to Call is lower than the Current Yield because the premium loss of $80 is accelerated over a shorter 3-year period rather than spread over the full 10-year maturity.
For a bond trading at a premium (price above par), the investor incurs a capital loss upon redemption at par. When the bond is called prior to maturity, this capital loss is compressed into a shorter time frame (3 years instead of 10 years), which reduces the investor's annualized return. Consequently, for premium callable bonds, Yield to Call (YTC) is the lowest yield metric (YTC < YTM < CY < Nominal Yield).

Step-by-Step Solution

1
Analyze the bond pricing status relative to par.
The bond trades at 1,080,whichisatapremiumtoits1,080, which is at a premium to its 1,000 par value.
Determining whether a bond trades at a discount or premium establishes the order of yield metrics.
2
Evaluate the impact of early redemption on premium amortization.
The investor pays 80abovepar.Ifcalledin3years,the80 above par. If called in 3 years, the 80 loss occurs over 3 years instead of 10 years.
Accelerating a capital loss reduces annual yield significantly compared to holding to full maturity.
3
Establish the yield hierarchy for a premium callable bond.
Nominal Yield > Current Yield > Yield to Maturity > Yield to Call.
Yield to Call represents the Yield to Worst (YTW) for a bond trading at a premium.

Key Concept

Yield Hierarchy for Premium Callable Bonds and Yield to Worst (YTW)
Estimated Time:2m 0s
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Topics

Debt Securities and Bond Structure

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