Question 1

Recently a high-yield corporate bond issuer sold $100 million of a 10-year corporate bond at par value at a yield to maturity of 6% (annualized). This bond was callable by the issuer at par at any time. The same issuer also issued a non-callable $100 million 10-year bond at par value at a yield to maturity of 5.5% (annualized). Both bonds have same seniority. These bonds were bought by institutional investors in capital markets. Which of the following statements are valid?

1. Callable bond has to pay a higher coupon because of default risk.
2. Callable bond gives the issuer the option to call the bond back from investors in future when interest rates fall or when the credit rating of the issuer improves. To compensate for this risk, investors demand a higher coupon on the callable bond.
3. Callable bond was preferred over non-callable bonds by institutional investors, resulting in the coupon differences.