It is now January 1, 2009, and you are considering the purchase of an outstanding bond

that was issued on January 1, 2007. It has a 9.5% annual coupon and had a 30-year
original maturity. (It matures on December 31, 2036.) There is 5 years of call protection
(until December 31, 2011), after which time it can be called at 109—that is, at 109% of
par, or $1,090. Interest rates have declined since it was issued; and it is now selling at
116.575% of par, or $1,165.75.
a. What is the yield to maturity? What is the yield to call?
b. If you bought this bond, which return would you actually earn? Explain your
reasoning.
c. Suppose the bond had been selling at a discount rather than a premium. Would the
yield to maturity have been the most likely return, or would the yield to call have been
most likely?

SOLUTION

a. Yield to maturity (YTM):

With a financial calculator, input N = 28, PV = -1165.75, PMT = 95, FV = 1000,
I/YR = ? I/YR = YTM = 8.00%.

Yield to call (YTC):

With a calculator, input N = 3, PV = -1165.75, PMT = 95, FV = 1090, I/YR = ?
I/YR = YTC = 6.11%.

b. Knowledgeable investors would expect the return to be closer to 6.1% than to 8%.
If interest rates remain substantially lower than 9.5%, the company can be
expected to call the issue at the call date and to refund it with an issue having a
coupon rate lower than 9.5%.

c. If the bond had sold at a discount, this would imply that current interest rates are
above the coupon rate (i.e., interest rates have risen). Therefore, the company
would not call the bonds, so the YTM would be more relevant than the YTC.