Pricing a Corporate Bond With a Make-Whole Call
An analyst must value a 7-year Bulgarian corporate bond with a face value of BGN 1,000, an annual coupon of 5.5%, and a make-whole call exercisable any time after year 3 at a price equal to the present value of remaining coupons and principal discounted at the yield on Bulgarian government securities plus 30 basis points. The issuer's credit spread has widened from 180 bp to 340 bp since issuance, and the comparable government yield curve is flat at 3.2%. The bond currently trades at a clean price of 94.50. A colleague argues the bond should be valued at par plus accrued interest because 'the coupon is above market.'
1. Calculate an approximate yield to maturity from the current clean price and explain why the colleague's par argument is wrong.
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Using the clean price of 94.50 (assume settlement just after a coupon date so accrued interest is near zero for approximation):
Annual coupon = 5.5% × 1,000 = BGN 55. With roughly 5.5 years remaining, approximate YTM ≈ [C + (F − P)/n] / [(F + P)/2] = [55 + (1,000 − 945)/5.5] / [(1,000 + 945)/2] = [55 + 10] / 972.5 ≈ 6.68%.
A more precise annual-compounding solve gives approximately 6.6–6.7%, consistent with a government yield of 3.2% plus a spread near 340 bp.
The colleague's error is conflating coupon with yield. A 5.5% coupon bond trades below par precisely because market yields (6.6%) exceed the coupon. Price and coupon move in opposite directions relative to market yield: the discount is the mechanism that raises the investor's return to the market level. Valuing at par would ignore both the credit deterioration and the required spread, overstating the bond by roughly 5.5 points.
2. Explain how the make-whole call affects the bond's upside and how it should influence valuation.
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The make-whole call caps the bond's price appreciation. If government yields fall sharply or the issuer's spread tightens, the bond would otherwise rally well above par. But the issuer can call it at the make-whole price, which is the present value of remaining cash flows discounted at the government yield plus 30 bp - a discount rate far below the bond's current market yield of about 6.6%. That call price sits close to the no-call value, so investors capture little of any rally beyond it.
Valuation implication: model the bond as the minimum of (a) the value assuming no call and (b) the make-whole call value plus the probability-weighted timing of exercise. Because the call is only valuable to the issuer when rates fall, the effective duration is lower than a straight bond's, and the yield-to-worst calculation should be used rather than yield-to-maturity alone. In the current environment, with the bond trading at a discount and spreads wide, the call is out of the money and yield-to-worst equals yield-to-maturity. But the analyst should still document the call feature, since a future spread tightening could trigger exercise and truncate upside - a material consideration for a client expecting capital gains.