Question

Two bonds have identical times to maturity and coupon rates. One is callable at 105, the other at 110. Which should have the higher yield to maturity?a. The bond callable at 110, should have the higher yield to maturity.b. The bond callable at 105, should have the higher yield to maturity.Which one is correct

Answer 1

The bond callable at 110 should have a higher yield to maturity than the bond callable at 105, as it poses a greater risk to the investor due to its higher callable price.

Step-by-step explanation:

The answer to this question involves understanding the relationship between bond yields and the callable feature of bonds. If two bonds have identical times to maturity and coupon rates but different callable prices, the bond callable at a higher price (110 in this case) should have a higher yield to maturity than the bond callable at a lower price (105). This is because the bond callable at 110 represents a greater risk to the investor; the issuing entity can retire the bond at a higher price, limiting the bond's potential price appreciation. To compensate for this risk, investors will demand a higher yield.

Therefore, the correct answer is:

• The bond callable at 110 should have the higher yield to maturity.

Answer 2

The bond callable at 110 should have a higher yield to maturity than the bond callable at 105 because it carries greater reinvestment risk and offers the issuer a greater incentive to call the bond early, requiring investors to be compensated for this additional risk.

Step-by-step explanation:

The bond callable at 110 should have the higher yield to maturity. This is because callable bonds present reinvestment risk to the bondholder; if interest rates decline, the issuer is likely to call the bond so they can refinance at a lower rate. Therefore, the bond callable at a higher price (110) has a higher reinvestment risk than the bond callable at 105 since it offers the issuer a greater incentive to call the bond early, should the interest rates fall. Investors require additional compensation for bearing this higher risk, which is reflected in a higher yield to maturity for the bond callable at 110 compared to the bond callable at 105.