Question

Six years ago the Templeton Company issued 20-year bonds with a 13% annual coupon rate at their $1,000 par value. The bonds had an 8% call premium, with 5 years of call protection. Today Templeton called the bonds. 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.

%

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

1. Investors should be happy. Since the bonds have been called, investors will no longer need to consider reinvestment rate risk.
2. Investors should not be happy. 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.
3. Investors should be happy. 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.
4. Investors should be happy. Since the bonds have been called, investors will receive a call premium and can declare a capital gain on their tax returns.

Answer 1

# of years held to call, NPER 6 [From the year the bond was issued initally to the current year when bond is called] a $130 [$1,000 x 13% as coupons are payable on bond's par value only] $1,000 [As it was issued at par value] $1,080 [$1,000 x 108% as it involves 8% call premium] 0 0 if coupons paid at the end of each year; 1 if coupons paid at the beginning of each year. 13.94% [Ref: NOTE Annual coupon payments, PMT Bond's initial purchase price, Pv Bond's call value today, FV Annual interest type, TYPE Bond's Yield to Call (YTC) NOTE: Bond's Yield to Call (YTC) is calculated using EXCEL FUNCTION RATE(nper,pmt,pv,fv,type) where nper-9; pmt-120; pv-1000; fv-1080; type-0; Here, t denotes outflow; type 0 as coupons paid at the end of each year only. value for pmt & fv are negative as they denote cash inflows; pv is positive as A C D 1#of years held to call, NPER 6 [From the year the bond was issued initally to the current year when bond is called] 2 Annual coupon payments, PMT 3 Bond's initial purchase price, PV -1000*13% [$1,000 x 13% as coupons are payable on bond's par value only] $1,000 [As it was issued at par value] -B3*108% [ $1,000 x 108% as it involves 8% call premium Bond's call value today, Fv 4 00 if coupons paid at the end of each year; 1 if coupons paid at the beginning of each year. Annual interest type, TYPE Bond's Yield to Call (YTC) 5 =RATE ( B1, - B2,B3,-B4,B5) [Ref: NOTE 6

Option-lI: Investors should not be happy. 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. NOTE YTM was 13% (=Coupon rate as the bond was initially issued at par) whereas YTC is 13.94%. Therefore, investors would be happy when bonds' are called more than YTC only. As the bonds are called callled today, it is obvious that interest rate would have fallen significantly. As a result, investors would like to invest in much lower interest rate environment and so Option-Il correctly describes this fact.