Explanation

Correct Answer: C. higher.

Key Concept: Convertible bonds typically offer lower yields than otherwise identical non-convertible bonds because the conversion option provides additional value to the bondholder.

Detailed Analysis:

1. Convertible Bond Features:

   • A convertible bond gives the bondholder the right to convert the bond into a fixed number of shares of the issuer's common stock.
   • This conversion option is valuable to investors because it allows them to participate in potential stock price appreciation.

2. Yield Relationship:

   • Since the convertible bond includes this valuable option, investors are willing to accept a lower yield (coupon rate) compared to a non-convertible bond.
   • The convertible bond's price will be higher (or its yield lower) than an otherwise identical non-convertible bond.

3. Lock-up Period Consideration:

   • The fact that the conversion option cannot be exercised for five years (lock-up period) makes the option slightly less valuable than an immediately exercisable option.
   • However, it still has significant value, so the convertible bond will still have a lower yield than the option-free bond.

4. Economic Rationale:

   • Investors pay a premium (in the form of accepting lower yield) for the conversion feature.
   • The non-convertible bond must offer a higher yield to compensate investors for not having the conversion option.

Example: If both bonds have the same credit quality, maturity, and other terms, the convertible bond might yield 4% while the non-convertible bond yields 5%. The 1% difference represents the value of the conversion option.

Conclusion: The option-free bond will have a higher yield than the convertible bond because investors require additional compensation for giving up the valuable conversion option.