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?

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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 days ago

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