Question

Prompt: Bonds are long term debt offerings issued by governments and corporations. Many corporate bonds contain a ‘call provision’. This feature requires the issuer to pay a price above par value when the bond is ‘called’. This is the call premium. Discuss why a bond issuer would use a call feature and then discuss the investor’s pricing of a bond with a call feature. Include a discussion of scripture as it applies to bonds as debt offerings.

Requirements: 250 words minimum

Answer 1

An issuer may choose to call a bond when market interest rates decline as compared to interest rate of the bond.. That way the issuer can save money by paying off the bond and issuing another bond at a lower interest rate. This is similar to refinancing the mortgage on your house so you can make lower monthly payments. Callable bonds are more risky for investors because an investor whose bond has been called faces reinvestment risk i.e reinvesting the money at a lower, less attractive rate.

lets underatand this with following example.

Xyz corpiration. issues bonds with a face value of $100 and a coupon rate of 5% while the current interest rate is 4%. The bonds will mature in 10 years.

the company issues the bonds with an call option to redeem the bonds from investors after the first five years.

If interest rates have declined after five years Xyz corporation may call back the bonds and refinance its debt with new bonds with a lower coupon rate. In such a case, the investors will receive the bond’s face value but will lose future coupon payments.

However, if the interest rate increases or remains the same, there is no incentive for the company to redeem the bonds and the call option will expire unexercised.

Valuing callable bonds differs from valuing regular bonds because of the call option. The call option negatively affects the price of a bond because investors lose future coupon payments if the call option is exercised by the issuer

The value of a callable bond can be found using the following formula:

Price of a callable bond = Price of straight bond - Price of put option

​​