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Series 7 practice questionhardDebt Securities — Bond Yields — YTC

A callable bond with a 7% coupon is purchased at $1,050. The bond is callable in 5 years at $1,020. Compared to the yield to maturity (YTM), the yield to call (YTC) will be:

  1. AHigher than YTM because the call price is above par
  2. BLower than YTM because the premium bond will be called earlier, reducing total return✓ Correct answer
  3. CEqual to YTM because the coupon rate does not change
  4. DCannot be determined without knowing the maturity date
Explanation

Why B — Lower than YTM because the premium bond will be called earlier, reducing total return

For a premium bond, YTC is typically lower than YTM. The bondholder paid $1,050 but would only receive $1,020 at the call date, realizing a capital loss of $30 over a shorter time period (5 years instead of the full maturity). The accelerated loss and shorter time frame to recoup the premium make the YTC less favorable. For premium bonds, the lower of YTC and YTM is the more conservative yield measure.

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