Examkin

Question

Difficulty: Very hardDebt Securities and Bond Structure

An investor is analyzing a 15-year corporate bond trading at 108 (% of par) with a 7.00% nominal coupon rate. The bond is callable in 5 years at par ($1,000). If market interest rates decrease further over the next year causing the yield curve to shift downward, which of the following statements correctly ranks the yields of this bond from lowest to highest, and accurately describes the likely pricing behavior of the bond as it approaches its call date?

  1. Yield to Call (YTC), Yield to Maturity (YTM), Current Yield (CY), Nominal Yield (NY); and the bond's secondary market price appreciation will be limited by call risk (compression effect near the call price).Answer
  2. B
    Nominal Yield (NY), Current Yield (CY), Yield to Maturity (YTM), Yield to Call (YTC); and the bond's secondary market price will fall because yields and prices move in the same direction.
  3. C
    Yield to Call (YTC), Yield to Maturity (YTM), Current Yield (CY), Nominal Yield (NY); and an inverted yield curve guarantees that short-term call prices will increase exponentially above par prior to call.
  4. D
    Yield to Maturity (YTM), Yield to Call (YTC), Nominal Yield (NY), Current Yield (CY); because state tax exemptions on corporate interest payments increase the effective yield to call above nominal yield.

Answer

Yield to Call (YTC), Yield to Maturity (YTM), Current Yield (CY), Nominal Yield (NY); and the bond's secondary market price appreciation will be limited by call risk (compression effect near the call price).
When a bond is purchased at a premium ($1,080), the investor receives annual interest based on the nominal coupon (7.00%), but faces a capital loss if held to maturity or call. Because the call date occurs earlier than the maturity date, the premium loss is accelerated over a shorter period, making Yield to Call (YTC) the lowest yield measure. Thus, the ascending yield order is YTC < YTM < CY < NY. Additionally, as market rates decline, the issuer is likely to call the bond, causing the bond price to exhibit call compression, where price gains flatten near the call price.

Step-by-Step Solution

1
Determine whether the bond is trading at a discount, par, or premium.
The bond is trading at 1,080(1081,080 (108% of par), which is at a premium above its 1,000 par value.
Establishing premium status determines the relative ranking order of all bond yields.
2
Establish the yield hierarchy for a bond trading at a premium.
For a premium bond, the yields from lowest to highest are: Yield to Call (YTC) < Yield to Maturity (YTM) < Current Yield (CY) < Nominal Yield (NY).
The premium amortizes over a shorter timeframe to the call date than to maturity, reducing YTC below YTM.
3
Evaluate the impact of falling interest rates on callable bond pricing behavior.
As interest rates fall, the price of a callable bond rises, but its appreciation is capped near the call price (par) due to call risk, known as premium compression.
Issuers are highly likely to call bonds when rates fall to refinance at lower rates.

Key Concept

Yield hierarchy of premium bonds and call risk pricing behavior
Estimated Time:2m 0s
Rate this question

Topics

Debt Securities and Bond Structure

More questions from this topic