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Difficulty: HardDebt Securities and Bond Structure

An investor acquires a 10-year corporate bond trading at a premium price of 1,080inthesecondarymarket.Thebondcarriesa61,080 in the secondary market. The bond carries a 6% annual coupon paid semi-annually and is callable in 4 years at par ( 1,000). Which of the following statements correctly identifies the yield metric representing the yield-to-worst (YTW) for this bond and accurately describes the hierarchy of its yield metrics?

  1. Yield to Call (YTC) represents the yield-to-worst, and the yield hierarchy from lowest to highest is YTC < YTM < CY < NY.Answer
  2. B
    Yield to Maturity (YTM) represents the yield-to-worst, and the yield hierarchy from lowest to highest is YTM < YTC < CY < NY.
  3. C
    Current Yield (CY) represents the yield-to-worst, and the yield hierarchy from lowest to highest is CY < YTM < YTC < NY.
  4. D
    Nominal Yield (NY) represents the yield-to-worst, and the yield hierarchy from lowest to highest is NY < CY < YTM < YTC.

Answer

Yield to Call (YTC) represents the yield-to-worst, and the yield hierarchy from lowest to highest is YTC < YTM < CY < NY.
For a bond purchased above par value (at a premium), the investor receives only par at maturity or upon early call, causing a loss of principal. When called prior to maturity, this premium loss is recognized over a shorter timeframe, driving the Yield to Call down below the Yield to Maturity. Thus, for premium callable bonds, the yield hierarchy from lowest to highest is YTC < YTM < CY < NY, making YTC the Yield-to-Worst.

Step-by-Step Solution

1
Determine the market price relationship to par value.
The market price (1,080)exceedsparvalue(1,080) exceeds par value ( 1,000), placing the bond at a premium.
Bond yield relationships (yield seesaw) depend on whether the security trades at a discount, par, or premium.
2
Analyze the impact of early redemption (call) on a premium bond.
If called in 4 years at par, the $80 premium paid is amortized over a shorter period than if held to the 10-year maturity.
Faster premium loss reduction reduces the annualized internal rate of return, making Yield to Call lower than Yield to Maturity.
3
Establish the yield hierarchy for premium bonds.
Yield to Call (YTC) < Yield to Maturity (YTM) < Current Yield (CY) < Nominal Yield (NY).
Nominal yield is based on par (60/60/ 1,000 = 6%), current yield on market price (60/60/ 1,080 = 5.56%), YTM factors in 10-year premium loss, and YTC factors in accelerated 4-year premium loss.
4
Identify the Yield-to-Worst (YTW).
Yield to Call is the lowest possible yield metric and constitutes the yield-to-worst.
Industry disclosure rules require reporting the lowest potential yield expected under contract terms.

Key Concept

Yield Hierarchy and Yield-to-Worst for Premium Callable Debt Securities
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Topics

Debt Securities and Bond Structure

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