Question

Mrs. G is looking to invest in a corporate bond, or a callable corporate bond. She has asked you to explain each and how they differ. Assume the following Par = $1,000, Coupon Rate = 5%, Market Rate = 6%, Remaining Term = 9 years, Remaining Term to Call = 4 years, typical call premium applies. • Give a write up comparing and contrasting the corporate bond and the callable corporate bond. • Use common models found in the text to help Mrs. Gunderstand how to evaluate potential returns from each Knowing that Mrs. G is very risk averse, make a recommendation, with support •

Answer 1

A CORPORATE BOND is a type of debt security that is issued by a firm and sold to investors. The company gets the capital it needs and in return the investor is paid a pre-established number of interest payments at either a fixed or variable interest rate.

A CALLABLE BOND is a type of corporate bond that the issuer may redeem before it reaches the stated maturity date. A callable bond allows the issuing company to pay off their debt early. A business may choose to call their bond if market interest rates move lower, which will allow them to re-borrow at a more beneficial rate. Callable bonds thus compensate investors for that potentiality as they typically offer a more attractive interest rate or coupon rate due to their callable nature.

Calculation of value of callable bond

Value = [FV(1+r)ⁿ]-CV

Where,FV = Face Value

r = coupon rate

n = time to call

CV = Call value (usually matches the bond's par value)

Hence, Value of callable bond = 1000(1.05)⁴-1000 = $215.51 (rounded off)

So total Amount receivable from the callable bond = 1000+215.51 = $1215.51

Calculation of value of corporate bond (When not called)

Value = Present value of interest and redemption value at Market rate = [1/(1+r)ⁿ]

Value = (1000x5%)[Annuity factor @6% for 9 years]+[1000x1/(1.06)⁹]

= (50x6.802)+(1000x0.592)

= 340.1+592

= $932.1 (rounded off)

Callable bonds are more risky for investors than non-callable bonds because an investor whose bond has been called is often faced with reinvesting the money at a lower, less attractive rate. As a result, callable bonds often have a higher annual return to compensate for the risk that the bonds might be called early.

Hence, Corporate bond is a better option for Mrs G being Risk averse.