Question

Lee is considering buying one of two newly-issued bonds. Bond A is a twenty-year, 7.5% coupon bond that is non-callable. Bond B is a twenty-year, 8.25% bond that is callable after two years. Both bonds are comparable in all other aspects. Lee plans on holding his bond to maturity. What should Lee do if he feels that interest rates are going to decline by 2% in the near future and then remain relatively stable thereafter

Answer 1

Multiple choices below are missing:

A) purchase Bond A

B) purchase Bond B

C) purchase neither A nor B at this time

D) negotiate a higher rate on Bond A

The correct option is A,purchase bond A.

Step-by-step explanation:

By purchasing Bond A,Lee is assured interest payment of 7.5% for a period of twenty years,hence the issuer cannot call the bond if interest rate drops by 2% in order to issue a lower interest-bearing bond which would be cheaper cost-wise.

However, if Lee purchases Bond B with current coupon of 8.25%,the interest is only guaranteed for a period of two years,since the issuer has the prerogative of calling back the bond after two years should interest fall in order to issue another bond that commands lower interest rate.