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Difficulty: MediumDebt Securities and Bond Structure

A corporate bond featuring a 6%6\% annual coupon rate is currently trading in the secondary market at a premium price of $1080\$1{}080. The bond is callable in five years at par ($1000\$1{}000). Which of the following yields represents the lowest return an investor purchasing the bond at its current market price can expect to receive?

  1. Yield to Call (YTC)Answer
  2. B
    Nominal Yield (NY)
  3. C
    Current Yield (CY)
  4. D
    Yield to Maturity (YTM)

Answer

Yield to Call (YTC) is the lowest yield for a callable bond trading at a premium.
For a bond purchased at a premium, the investor pays more than the face value that will be returned at redemption. If the issuer exercises the call option prior to maturity, the premium lost by the investor is accelerated over a shorter timeframe, reducing the annual rate of return. Consequently, Yield to Call (YTC) is the lowest among all yield measures for a premium bond.

Step-by-Step Solution

1
Identify the relationship between market price and par value.
The bond is trading at a premium ($1080\$1{}080 market price vs. $1000\$1{}000 par value).
Determining whether a bond trades at a discount or premium dictates the order of its yield hierarchy.
2
Apply the yield hierarchy rule for bonds trading at a premium.
For premium bonds: Nominal Yield>Current Yield>Yield to Maturity>Yield to Call\text{Nominal Yield} > \text{Current Yield} > \text{Yield to Maturity} > \text{Yield to Call}.
An investor paying a premium suffers a capital loss when the bond is redeemed at par; calling the bond early accelerates this capital loss, resulting in Yield to Call being the lowest yield.

Key Concept

Yield Hierarchy for Premium Callable Bonds
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Topics

Debt Securities and Bond Structure

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