Question

Maturity	April 3, 2019
Coupon (current)	5.5%
YTM	5.5%
Callable?	Yes (currently callable)
Call Price	102

You are an interest rate contrarian - unlike the rest of the market, you project that 10-year Treasury Note rates will decrease by 100 bps in one year. In your view, is it a good or bad time to buy this bond?

Answer 1

In my viewpoint, it is a bad time to buy this bond.

Since the current coupon rate and YTM are the same at 5.50%, the bond can be purchased for the par value of $100 from the market today.

To understand the problem better, I have calculated the interest payments of the bond that I will receive at the rate of 5.50% and 4.50% (due to fall in rates by 100 basis points) for one year:

The interest payments from the bond without fall in interest rate is the par value multiplied by the existing coupon rate that is $100 * 5.50% = $5.50.

The interest payments from the bond with interest rate fall is the callable bond rate multiplied by the reduced interest rate that is $102 * 4.50% = $4.59 = $4.60 (Rounded Off).

Clearly, the value that I will receive as an investor is higher if the call option is not exercised. However, being an interest rate contrarian, I expect the interest rate to fall and so the issuer is expected to exercise the call option (because their payment expense is lower if they exercise the call option).

Therefore, purchasing the bond now is not a good choice.