A boad matures in ten years, pays a 7% semiannual coupon, and is currently priced to yield 6.25%. The bond is callable at par beginning five years from now.
Debbie Scott is planning to purchase this bond. Scott can currently reinvest coupon income from the bond at 5.50%. Which of the following statements is least accurate?
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A. B. C.C
Let's analyze each statement one by one:
A. If the bond is called in six years, Scott's return will be less than 6.25%. When a bond is callable, it means that the issuer has the right to redeem or "call" the bond before its maturity date. If the bond is called, the bondholder will receive the call price, typically the face value of the bond, and will stop receiving coupon payments.
In this case, the bond is callable beginning five years from now. If the bond is called in six years, it means it is called before its maturity date of ten years. As a result, Debbie Scott will not receive the full coupon payments for the remaining four years. Instead, she will receive the call price, which is the face value of the bond.
Since the bond is currently priced to yield 6.25%, this means that the yield reflects both the coupon payments and the expected call price. If the bond is called in six years, Scott's return will be lower than 6.25% because she will not receive the remaining coupon payments for the four years until maturity.
Therefore, statement A is accurate.
B. If Scott's reinvestment rate was 6.25%, the bond's yield to worst would be less than 6.25%. The yield to worst of a bond is the lowest yield among its yield to maturity (YTM) and its yield to call (YTC). The YTM is the yield if the bond is held until its maturity date, while the YTC is the yield if the bond is called at the earliest call date.
In this statement, it says that Scott's reinvestment rate is 6.25%. If Scott's reinvestment rate matches the bond's yield, it implies that she can reinvest the coupon payments at the same rate as the bond's yield. However, the bond's yield to worst would be less than 6.25% because the reinvestment rate matches the yield to maturity, not the yield to call.
Since the bond is callable at par beginning five years from now, it means that the issuer can call the bond and repay the face value of the bond. If the bond is called before its maturity, Scott will not receive the remaining coupon payments, and her reinvestment rate will not be relevant in that scenario. Therefore, the yield to worst will be lower than 6.25%.
Hence, statement B is accurate.
C. If the bond was priced to yield 5.50%, the current yield would be 7%. The current yield of a bond is calculated by dividing the annual coupon payment by the bond's current market price. It represents the income an investor receives from the bond relative to its current price.
In this statement, it says that the bond is priced to yield 5.50%. This means that the yield reflects the coupon payments and the current market price of the bond. However, the bond's semiannual coupon rate is 7%.
The current yield is calculated based on the annual coupon payment divided by the bond's market price. If the bond is priced to yield 5.50%, it means the bond's market price is higher, and therefore the current yield will be lower than the coupon rate.
Therefore, statement C is inaccurate. The current yield would be lower than 7%.
To summarize: A. If the bond is called in six years, Scott's return will be less than 6.25%. (Accurate) B. If Scott's reinvestment rate was 6.25%, the bond's yield to worst would be less than 6.25%. (Accurate) C. If the bond was priced to yield 5.50%, the current yield would be 7%. (Inaccur