Yield to call Six years ago the Singleton Company issued 28-year bonds with a 13
ID: 2613087 • Letter: Y
Question
Yield to call
Six years ago the Singleton Company issued 28-year bonds with a 13% annual coupon rate at their $1,000 par value. The bonds had a 8% call premium, with 5 years of call protection. Today Singleton called the bonds.
Compute the realized rate of return for an investor who purchased the bonds when they were issued and held them until they were called. Round your answer to two decimal places.
%
Explain why the investor should or should not be happy that Singleton called them.
Since the bonds have been called, interest rates must have risen sufficiently such that the YTC is greater than the YTM. If investors wish to reinvest their interest receipts, they can now do so at higher interest rates.
Since the bonds have been called, interest rates must have risen sufficiently such that the YTC is greater than the YTM. If investors wish to reinvest their interest receipts, they must do so at lower interest rates.
Since the bonds have been called, investors will receive a call premium and can declare a capital gain on their tax returns.
Since the bonds have been called, investors will no longer need to consider reinvestment rate risk.
Since the bonds have been called, interest rates must have fallen sufficiently such that the YTC is less than the YTM. If investors wish to reinvest their interest receipts, they must do so at lower interest rates.
Explanation / Answer
A) Realized Return = Realized Gain/Cost of investment x 100
This is what you will use to calculate your realized return as a percentage of your total investment.
Amount above the par value of a bond that its issuer must pay to the holders if the bond is redeemed before its maturity date. Call premium usually declines with the years of the bond's issue date; it is higher for bonds called after 5 years than for those called after 10 years. It compensates the bond holder for disruption in interest earnings, and for the effort to reinvest funds. In this case call protection is 5 years which means the issure can call back the bonds after 5 years.So Singelton company has right to call back after 5 years in this case it is doing after 6 years.
Realized Return = Realized Gain/Cost of investment x 100
Realized gain in this case will be the interest earned 13% annually and also 8% call premium
Realized Return= (13% on $1000 annually for 6 years + 8% call premuim on $1000) / 1000 *100
Realized Return = (780 + 80) / 1000 *100
Realized Return = 86.00%
In this case, one would have earned a 86.00% percent realized return.
B) The investor should not be happy that Singleton called them because investors that own callable bonds with a market price above the call price don’t want to be called. The investor would take an immediate loss when compared to the bond’s current market price and not be able find other bonds paying the same yield as they are currently receiving. A double loss! As a result, you might not want to buy a bond selling at a premium with a near-term upcoming call date. The bigger the premium of the bond, the more the call hurts the bondholder.
C) Basically, you can think of the yield to call as (the interest earned + (sale price – purchase price) divided by the purchase price of the bond divided by the number of years the bond is held.*
In this case, the yield to call would be ($650 + ($1080 – $1000)) / $1000 / 5 = 3.65
Basicly, you can think of the yield to maturity as (the interest earned + (principal value – purchase price) divided by the purchase price of the bond divided by the number of years the bond is held.*
In this case, the case the yield would be ($780 + ($1080 – $1000)) / $1000 / 6 = 5.18
As you can tell the yield to call is much lower than the yield to maturity. The key idea is that the longer the bond holder has to capture interest on the bond, the less of the impact the loss of value will have.
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