Callable Bond

On a callable bond trading at a premium, the lowest yield is usually the:

1. A.Yield to callCorrect - YTC is lowest for a premium callable.
2. B.Yield to maturityA defensible pick, since yield to maturity on a premium bond does fall below the coupon as the premium amortizes. But the call comes sooner, so the same premium is written off over fewer years, driving yield to call below it. YTM is the second lowest here, not the lowest.
3. C.Nominal yieldNominal yield is the coupon printed on the bond, fixed regardless of what the investor paid. On a premium bond it is the highest of the four measures, because every other yield is pulled down by the price above par.
4. D.Current yieldCurrent yield divides the coupon by the premium price, so it does come in under the nominal yield, which is what makes it tempting. It stops there, though, ignoring the capital loss from paying above par and receiving only par or the call price. That leaves it between nominal and the two yields that do count the loss.

Why: For a premium callable bond, the yield to call is typically the lowest (yield to worst).

Which of the following is essentially free of reinvestment risk on its coupons?

1. A.An equity REITA REIT is not a coupon instrument; the reinvestment-risk concept applies to bond cash flows.
2. B.A callable bondIf called when rates fall, the investor must reinvest the proceeds at lower yields.
3. C.A zero-coupon bondCorrect — with no coupons, there is nothing to reinvest.
4. D.A coupon-paying corporate bondIts periodic coupons must be reinvested, creating reinvestment risk.

Why: A zero-coupon bond pays no periodic interest, so there are no coupons to reinvest — it carries essentially no reinvestment risk. Coupon-paying and callable bonds do carry it.

An issuer is most likely to call a callable bond when interest rates have:

1. A.Risen sharplyRising rates make the outstanding bond's coupon look cheap to the issuer, which is precisely when it wants to keep the old debt outstanding. Calling then would force it to refinance at a higher rate.
2. B.FallenCorrect - refinance at lower rates.
3. C.Never (calls are random)This confuses the random lot selection used to decide which individual bonds within an issue get redeemed with the issuer's decision on whether to call at all. The decision to exercise the call is an economic one driven by refinancing cost, not chance.
4. D.Stayed flatFlat rates give the issuer no savings to capture, and calling still costs it the call premium and a new underwriting. Without a rate decline there is nothing to gain by retiring the bond early.

Why: Issuers call bonds after rates fall so they can refinance at lower cost, creating reinvestment risk for the holder.

The Cedar Point Water Authority's revenue bond indenture provides for a SINKING FUND and separately contains a CATASTROPHE CALL provision. What do these two features do?

1. A.Both permit the issuer to redeem bonds at its option whenever interest rates fall enough to make refinancing attractive.Wrong. That describes an optional call. Neither a sinking fund nor a catastrophe call is exercised on the basis of interest rate movements.
2. B.The sinking fund sets money aside on a schedule to retire bonds before maturity, while the catastrophe call mandates redemption of the issue if the financed facility is destroyed and insurance proceeds are received.Correct. One is a scheduled retirement mechanism; the other is a mandatory call triggered by destruction of the facility.
3. C.Both are credit enhancements purchased from a third-party municipal bond insurer.Wrong. Both are provisions of the issuer's own indenture. No third party is involved.
4. D.The sinking fund guarantees interest payments if revenues fall short, while the catastrophe call protects bondholders against default.Wrong. A sinking fund retires principal; it is not a debt service reserve fund. And a catastrophe call is a redemption trigger, not default protection.

Why: They serve different purposes. A sinking fund requires the issuer to set money aside on a schedule and use it to retire bonds before maturity, either by calling them or by buying them in the open market. It reduces the amount outstanding over time and is generally viewed as a credit strength, since the issuer is not left facing the whole principal at once. A catastrophe call - sometimes called a calamity call - is a MANDATORY redemption triggered when the financed facility is destroyed: insurance proceeds arrive, the facility can no longer generate the pledged revenue, and the bonds are called, typically at par.