Question

"Bond Prices and Yields"

Please respond to the following: Speculate as to why an investor may buy into callable bonds versus convertible bonds when prices are dropping. Provide support for your rationale.

Determine two reasons that the stated yield to maturity and realized compound yield to maturity of a default free zero coupon bond must always be equal. Support your answer with examples.

Answer 1

Callable Bond can be redeemed by the issuer before the maturity and provides higher rate to the investor as it's a risk from investor's perspective. When prices are dropping the convertible bond will be priced lower when they are converted into equity and it would be loss for the investor. As callable bond higher interest rate than normal bond/convertible bond the loss will be minimized for the investor.So, callable bond is preferred over convertible bond when prices are dropping.

Say, the principle amount is $100 and the annual coupon rate is 10%. If the bond is priced at par, for 1 year maturity bond the yield is 10%. For same scenario, the zero coupon bond will be issued at $90.9 and at the end of maturity i.e.1st year the investor will get $100. So, the yield here also 10%.So, the yield for both the cases are same. Basic assumption for creation of zero coupon bond is the the final maturity value should include the principle and the interest accumulated for the period and hence interest for the normal bond should be equal if it is held until maturity.