It is now January 1, 2001, and you are considering the purchase of an outstanding Racette Corporation bond that was issued on January 1, 1999. The Racette bond has a 9.5 percent annual coupon and a 30-year original maturity (it matures on December 31, 2028). There is a 5-year call protection (until December 31, 2003), after which time the bond can be called at 109 (that is, at 109 percent of par, or $1,090). Interest rates have declined since the bond was issued, and the bond is now selling at 116,575 percent of par, or $1,165.75. You want to determine both the yield to maturity and the yield to call for this bond. (Note: The yield to call considers the effect of a call provision on the bond’s probable yield. In the calculation, we assume that the bond will be outstanding until the call date, at which time it will be called. Thus, the investor will have received interest payments for the call-protected period and then will receive the call price – in this case, $1,090 – on the call date.)
a. What is the yield to maturity in 2001 for the bond? What is its yield to call?
b. If you bought this bond, which return do you think you would actually earn? Explain your reasoning.
c. Suppose the bond had sold at a discount. Would the yield to maturity or the yield to call have been more relevant?