Question

Bill owns a corporate bond that is priced at $115, has a 9 percent coupon rate, and 15 years remaining to maturity. The bond pays interest annually and is callable at year five where the bond issuer will pay the $100 par value plus a $1 call premium.

1. What is the bond’s yield to maturity?

2. What is the bond’s yield to call?

3. Which yield more accurately reflects the yield Bill will earn on the bond? Explain your answer.  

9.         Assume Bill’s bond in question eight pays interest semiannually rather than annually. All the other information is the same.

1. What is the bond’s yield to maturity?

2. What is the bond’s yield to call?

Answer 1

Ques 8

a) Bond's YTM= (C + (F - P) / t) / ((F + P) / 2)

Where, C= coupon received by investors

F= Face value/ par value

P= Price of the bond

t= no. of years to maturity

YTM=   (9 + (100 - 115) / 15) / ((100 + 115) / 2) = 7.44% (approx)

b) Bond's Yield to call= YTC = (C + (CP - P) / t) / ((CP + P) / 2)

Where, C= coupon received by investors

CP= Call price of the Bond

P= Price of the bond

t= no. of years remaining until the call date

YTC=  (9 + (101- 115) / 5) / ((101 + 115) / 2)= 5.74% (Approx)

c) Yield to maturity measures the return that the investor can expect to earn till maturity of the bond.

Yield to Call measures the return that the investor can expect to earn till the bond is callable. A callable bond is a bond which gives the bond issuer a chance to redeem the bond earlier than its maturity. Hence, the issuer calls the bond when the interest rates in the market falls, so that it can raise funds from bonds again at lower rates. Callable bonds offer a higher coupon rate owing to its callable nature.

YTM is a better estimate of yield earned by an investor because it shows the yield over the life of the bond. YTC is an uncertain estimate to an extent because as investors have no idea when or if the issuer will call the bond or not. For example, in this question, we have calculated YTC based on 5 years, but the issuer may call the bond on a different day or maybe wait until the next call date.