A client holds a 10-year bond with a 6% coupon rate, currently yielding 5%. The bond has a call provision that allows the issuer to redeem it at par in three years. If interest rates are expected to drop significantly in the next year, how might this impact the client?

Question: A client holds a 10-year bond with a 6% coupon rate, currently yielding 5%. The bond has a call provision that allows the issuer to redeem it at par in three years. If interest rates are expected to drop significantly in the next year, how might this impact the client?

Answer options:

• The value of the call option to the issuer decreases, benefiting the client. ✅ The bond's yield to call (YTC) will likely become more relevant than its yield to maturity (YTM).
• The client will earn a higher return if the bond is called than if it matures.
• The call provision becomes irrelevant as interest rates fall.

Correct answer: The bond's yield to call (YTC) will likely become more relevant than its yield to maturity (YTM).

Explanation: If interest rates drop, the issuer is more likely to call the bond to refinance at a lower rate. In this scenario, the investor will receive the call price, and the Yield to Call (YTC) becomes the more relevant measure of potential return.