Question

Which of this sentences are true or false? Please explain briefly. 1) “Callable bonds are more likely to be called if interest rates have increased since the issuance of the bonds.” 2) “When trading bonds with coupons, the bond seller must pay a portion of the next coupon, representing accrued interest, to the bond buyer.”

Answer 1

1) False

Explanation: Issuers will call bonds when interest rates will drop since the issuance of bonds. This feature acts as a benefit to the issuer but hurts the investors. Issuers provide the incentive to the investors by paying higher interest rates on callable bonds. The nature of the callable bond marks that the price of it will not rise above its call price, irrespective of how low-interest rates will go. This is so because dropping interest rates will increase its chance that it will be called. Here, investors face the prospect of re-investing at lower interest rates.

For example: if the bond is issued at a rate of 6% and the market rate for the bonds of that type drops to 5% and stays there when the bonds become callable the issuer is likely to call it in order to issue new bonds at 5%.

2) False

Explanation: The secondary market allows the owner of the bond to sell at any time. But the case of accrued interest (interest earned from the date of purchase till the date of selling) is the sole earnings of the bondholder on the coupon so attached. The buyer of the bond thus is required to compensate the seller of the accrued interest so earned by the seller as the final interest would be received by the buyer on the date of maturity. It thus becomes necessary for the buyer to pay the seller the portion of the interest that the seller earned before selling the bond as part of the total purchase price.