Which of the following statements is CORRECT?
a. Two bonds have the same maturity and the same coupon rate. However, one is callable and the other is not. The difference in prices between the bonds will be greater if the current market interest rate is below the coupon rate than if it is above the coupon rate.
b. A callable 10-year, 10% bond should sell at a higher price than an otherwise similar noncallable bond.
c. Corporate treasurers dislike issuing callable bonds because these bonds may require the company to raise additional funds earlier than would be true if noncallable bonds with the same maturity were used.
d. Two bonds have the same maturity and the same coupon rate. However, one is callable and the other is not. The difference in prices between the bonds will be greater if the current market interest rate is above the coupon rate than if it is below the coupon rate.
e. The actual life of a callable bond will always be equal to or less than the actual life of a noncallable bond with the same maturity. Therefore, if the yield curve is upward stoping, the required rate of return will be lower on the callabe bond.
To determine which statement is correct, let's assess each option:
a. This statement is correct. When the current market interest rate is below the coupon rate, the callable bond has a higher likelihood of being called. As a result, its price will be lower compared to the noncallable bond, which does not have the risk of being called. Therefore, the difference in prices between the bonds will be greater in this scenario.
b. This statement is incorrect. A callable bond usually sells at a lower price than an otherwise similar noncallable bond. The investor is compensated for the possibility of early redemption by the issuer, which reduces the value of the call feature. Consequently, the callable bond tends to have a lower price.
c. This statement is correct. Corporate treasurers often dislike issuing callable bonds because they grant the issuer the ability to redeem the bonds before maturity. This potential early redemption may require the company to raise additional funds sooner than if noncallable bonds were issued. Thus, callable bonds can pose an earlier funding risk for the company.
d. This statement is incorrect. When the current market interest rate is above the coupon rate, the callable bond is less likely to be called, as it becomes less advantageous for the issuer to do so. Therefore, the callable bond will have a higher price compared to the noncallable bond, resulting in a smaller difference in prices between the two.
e. This statement is incorrect. The actual life of a callable bond can be equal to or less than the actual life of a noncallable bond, depending on whether the callable feature is exercised. If the bond is called before its maturity, its actual life will be shorter. However, if the bond is not called, its actual life could be the same as a noncallable bond. Therefore, the claim that the actual life will always be equal to or less than a noncallable bond is not accurate.
Based on the explanations provided, the correct statement is:
a. Two bonds have the same maturity and the same coupon rate. However, one is callable and the other is not. The difference in prices between the bonds will be greater if the current market interest rate is below the coupon rate than if it is above the coupon rate.