What can you say about the yield to maturity on a callable bond compared to an...

What can you say about the yield to maturity on a callable bond compared to an otherwise identical straight bond? Why?

Expert Solution

The yield to maturity (y) of any bond and the bond's price are inversely related by means of the following equation:

Bond Price = Bond Coupon x (1/y) x [1-{1/(1+y)^(Bond Tenure)}] + Bond Par Value / (1+y)^(Bond Tenure)

As is observable, a rise in the bond's price will depress the yield to maturity and vice-versa.

Callable Bond's have a call option embedded in them which allows the bond issuer to call the bonds when interest rates go down (so as to be able to re-issue the bond at the prevailing lower interest rate).As is understandable, the bond with such an option embedded in it will be advantageous to the issuer and dis-advantageous to the buyer. Hence, the buyer will pay a lower price for the callable bond as compared to a straight bond, so as to be compensated for this disadvantage.

Consequently, a callable bond will have a lower price as compared to a similar straight bond. This implies that a callable bond will have a higher yield to maturity as compared to a straight bond.

jeff jeffy answered 6 months ago

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