Question

Dr. Power has been offered some 15-years maturity bonds that cost her $1,210 each with an annual coupon rate of 7% compounding quarterly. Unfortunately, those bonds are callable in 7 years at 1,300. She was wondering about the yield curve but her son who is the financial advisor to, Mr. Power, the richest man in Sioux City, confirmed that the yield curve will still remain horizontal with rates expected to remain at current levels onto the future. Under these conditions, what rate of return should Dr. Anne expect to earn if she purchases these bonds?

Answer 1

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Callable bonds meaning:
It is a long term fixed rate Bond where the issuer enjoys a call option that is right to buy back the bonds from the investors prior to maturity at a predetermined price known as call price. the call price is usually at a premium to face value.

The issuer will obviously call the bonds (that is refund prior to maturity) if the interest rate(i.e YTM in this case) is less than coupon rate because the entity can borrow at lower rates.

When interest rate falls, the bond are price is retired at their predetermined value.

Hence the expected rate of return is yield to call (7.41%).