Question

Six years ago the Templeton Company issued 21-year bonds with a 14% annual coupon rate at their $1,000 par value. The bonds had a 9% call premium, with 5 years of call protection. Today Templeton called the bonds.

Required:
a. 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.

b. Why the investor should or should not be happy that Templeton called them.

I. 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.
II. 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.
III. Since the bonds have been called, investors will receive a call premium and can declare a capital gain on their tax returns.
IV. Since the bonds have been called, investors will no longer need to consider reinvestment rate risk.
V. 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

a. 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.

HPR = [(ending price - actual price) + dividends received] / actual price

HPR = [($1,090 - $1,000) + (6 x $140)] / $1,000 = $930 / $1,000 = 93%

b. Why the investor should or should not be happy that Templeton called them.

• V. 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.

The investor should be unhappy because the market interest rates were much lower than 14%. A company will repurchase bonds only if the market rates are much lower than the current coupon rates that they are paying. Even after paying the call premium, the company is still saving money.

On the other hand, if the investor wants to reinvest the $1,090 received per bond, they will earn a lower interest rate.