Question

Seven years ago the Templeton Company issued 17-year bonds with a 11% annual coupon rate at their $1,000 par value. The bonds had a 5% call premium, with 5 years of call protection. Today Templeton 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
Why the investor should or should not be happy that Templeton called them.
a)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.
b)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.
c)Since the bonds have been called, investors will receive a call premium and can declare a capital gain on their tax returns.
d)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.

Answer 1

The realized rate of return for an investor holding the called Templeton Company bonds includes coupon payments plus a 5% call premium. The correct option indicating why an investor might be displeased with the call is (d), as it means reinvesting at lower interest rates due to the fall in market rates since the bond's issuance.

Step-by-step explanation:

When the Templeton Company issued 17-year bonds with an 11% annual coupon rate seven years ago, an investor who purchased the bonds at their $1,000 par value and held them until they were called would need to compute their realized rate of return. Since the bonds had a 5% call premium and were called after 12 years (7 years ago plus 5 years of call protection), the investor would receive the par value plus the call premium. The call premium is 5% of $1,000, which is $50, so they would receive $1,050 in total, plus coupon payments made during the period they held the bond.

The realized rate of return is calculated based on the coupon payments received over the years, plus the call premium and the redemption at par value, all in comparison to the original purchase price of the bond. As for whether an investor should be happy about the bonds being called, the answer is option (d). Since the bonds have been called, interest rates must have fallen sufficiently such that the yield to call (YTC) is less than the yield to maturity (YTM). The investor will now face the predicament of reinvesting the returned capital at lower interest rates, which could result in decreased income. This occurs because when interest rates fall, new bonds on the market offer lower rates than the older, higher-rate bonds.