Question

Part1: From the perspective of bondholders, callable bonds pose at least two disadvantages when compared to non-callable bonds. Name and briefly describe these two disadvantages. (3 pts)

Part2: Given the following information:

Current Interest Rate is 7%
Now, the Interest Rate can immediately jump to 6% or 4%

Callable Bond's information:
Maturity is 14
Coupon is 7%
Par value is 1000
Call Price is 1100

In each of the interest rate scenarios described above, which of the two disadvantages do investors suffer from? (3 pts)

Explain why? (Assuming that there is no call protection) (3 pts)

NOTICE: If you need to show some numbers, please show the calculations as well.

Answer 1

A callable bond, also known as a redeemable bond, is a bond that the issuer may redeem before it reaches the stated maturity date. A callable bond allows the issuing company to pay off their debt early. A business may choose to call their bond if market interest rates move lower, which will allow them to re-borrow at a more beneficial rate.

Disadvantages:

1) Investors cannot take advantage of higher prices when the market rate falls. As soon as market rate falls below a certain level, issuer will call back the higher coupons bond and issue a fresh bond with lower market rate.

2) As investors face a reinvestment risk once the bonds are called. This significanlty impacts the expected return of the whole portfolio.

3) Price of the bond will mostly will not rise beyond the call price. As if it crosses, mostly the issuer will call back the bond.

Lets take the example

What will be the price of the bond if Interest rate is 6%

Feed following in Financial calculator:
n = 14 years

PMT = 70

FV = 1000

I.Y = 6%

Comput PV, we get = 1092.95

Similarly we solve for Interest Rate of 4%:

n = 14 years

PMT = 70

FV = 1000

I.Y = 4%

Comput PV, we get = 1316.89

If the interest rate falls below to 4%, the bond price exceeds the call price of 1100, hence there are chances that bond may be called back by the issuer by issuing fresh bond at lower rate of interest. Hence, investors will be unable to take the advantage of falling interest rates.