) Six years ago the Singleton Company issued 20-year bonds with a 14% annual coupon rate at
their $1,000 par value. The bonds had a 9% call premium, with 5 years of call protection.
Today Singleton 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. Explain
why the investor should or should not be happy that Singleton called them.
To compute the realized rate of return for the investor who purchased the bonds when they were issued and held until they were called, we need to consider the cash flows involved.
Step 1: Calculate the total coupon payments received over the holding period:
The bonds have a 14% annual coupon rate on a $1,000 par value, so the annual coupon payment is (0.14 * $1,000) = $140.
The holding period is 6 years, so the total coupon payments received would be ($140 * 6) = $840.
Step 2: Determine the call price of the bonds:
The bonds have a 9% call premium, which means that Singleton will pay a 9% premium over the par value to call the bonds. Therefore, the call price would be ($1,000 + (0.09 * $1,000)) = $1,090.
Step 3: Calculate the total cash received from the call:
Since the bonds were called after 6 years, the investor would receive the call price of $1,090.
Step 4: Compute the realized rate of return:
The realized rate of return is the total cash received divided by the initial investment. In this case, we need to calculate the initial purchase price of the bonds.
Given that the bonds were issued at their $1,000 par value and were held until they were called, there should not be any capital gains or losses. Hence, the initial purchase price remains at $1,000.
So, the realized rate of return is ($1,090 + $840) / $1,000 = 1.93 or 193%.
Explanation for investor's happiness:
The investor should be happy that Singleton called the bonds because the realized rate of return is 193%, which is significantly higher than the coupon rate of 14%. The investor received both the coupon payments of $840 and the call price of $1,090, resulting in a substantial profit. As a result, the investor has earned a higher return than originally anticipated, making the call of the bonds a favorable outcome.