Question

Define a callable bond. How is a callable bond different from a non-callable bond?

- Consider a non-callable bond with an 8% coupon and with yield to maturity = 10%.  If the bond’s yield to maturity remains constant, then in one year will the bond price be higher, lower, or unchanged?  Why?

- A 30-year maturity, 8% coupon bond paying coupons semiannually is callable in 5 years at a call price of $1100.  The bond currently sells at a yield to maturity (YTM) of 7% (3.5% per half-year). What is the yield to call? How does it relate to the YTM? Why?    

ANSWER BOTH PLEASE

Answer 1

A. A callable bond is a bond which which gives right to an issuer to call back the bond anytime before the maturity of the bond.When interest rate falls then to take advantage of lower interest rate the issuer might call back the bond.

Callable bond is different from non callable bond as it has higher rate of interest because the investor in callable bond has to face reinvestment risk in case the bond is called back at par value.  Usually at time of call back of bond the investor might receive a call premium to compensate for this risk. Normal bonds are redeemed at par value.

Since the coupon rate is less than YTM the bond is sold at discount. After one year the price of bond will increase. This is because the price of a discount bond increases as it approaches maturity. In a premium bond the price of bond decreases as it approaches maturity.Hence after 1 year the bond price will increase.

B.Number of Periods f Bond =30*2 =60
Semi Annual Coupon =8%*1000/2 =40
Semi annual YTM =3.5%
Price of Bond =PV if Coupons+PV of Par Value =40*((1-(1+3.5%)^-60)/3.5%)+1000/(1+3.5%)^60 =1124.72

Call Price =1100
Price of Bond =1124.72
Call Price =1100
Number of Periods =5*2 =10
YTC using Financial Calculation
N=10;PMT=40;PV=-1124.72;FV=1100;CPT I/Y =3.376%
YTC =2*3.376% =6.75%

Yield to call is less than Yield to Maturity. This is because the bond is called at a much shorter duration as compared to normal bond.