Question

Yield to call

Ten years ago the Templeton Company issued 25-year bonds with a 9% annual coupon rate at their $1,000 par value. The bonds had a 6% call premium, with 5 years of call protection. Today Templeton called the bonds.

1. 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.
   
   %
   
2. Why the investor should or should not be happy that Templeton called them.
   1. 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.
   2. 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.
   3. Since the bonds have been called, investors will receive a call premium and can declare a capital gain on their tax returns.
   4. Since the bonds have been called, investors will no longer need to consider reinvestment rate risk.
   5. 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). To find the realized return, we need to put the following values in the financial calculator:

INPUT	10		-1,000	9%*1,000=90	1,000 + 6% = 1,060
TVM	N	I/Y	PV	PMT	FV
OUTPUT		9.39

Hence, Realized Rate of Return = 9.39%

b). Statement V is correct.

Despite a 9.39% return on the bonds, investors are not likely to be happy that they were called. Because if the bonds have been called, this indicates that interest rates have fallen sufficiently that the YTC is less than the YTM. (Since they were originally sold at par, the YTM at issuance = 9%.) Rates are sufficiently low to justify the call. Now investors must reinvest their funds in a much lower interest rate environment.