Question

Consider several bonds for investment: a) a noncallable bond currently priced at par, b) a callable bond currently priced at par, a noncallable bond currently price at a significant discount to par. You expect the yield curve to shift down dramatically. Which bond to you want to own?

Answer 1

Callable bonds are the bonds that are redeemable or paid off by the issuer before the maturity of the bond.

-How does it work?: The issuer when calls the bonds before the maturity of the bonds pays the buyer of the bonds the Call price, usually the face value of the bond, and the accrued interest to that date and some call premium then after that stops making the interest payment(coupon payments).

-What is the amount paid by the issuer?: The amount equals the call price (or Face Value) and the call premium along with the accrued interest.

Accrued interest is calculated by discounting the future interest payments with the current prevailing interest rate.

Case Scenario: Yield curve to shift down: means the future market interest rates would decline. Rate of return in the market would decrease.

In such case, it is preferred to choose the callable bonds as the issuer has the choice to call the bond when the market interest rates fall and reissue the bond at the declined rate to pay fewer interest payments(coupon payments).

So looking the given scenario, the issuer should go for the callable bonds currently priced at par.

And between option (b) and (c), it would depend on the coupon rate, if the coupon rate is less than the future interest rates than the go for the option (c).