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In: Finance

In 250 word,Bonds are long term debt offerings issued by governments and corporations. Many corporate bonds...

In 250 word,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. Please no plagiarism

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Expert Solution

Callable bonds are bonds that can be called by the issuer before the bonds reach the date of it's maturity.

As callable bonds benefit the issuer, and leaves the bond holders with reinvestment risk, that is the risk that the money they received back from the issuer has to be reinvested at a lower rate. Yes, as the call feature in the callable bonds leaves the investors with uncertainty, the issuer have to pay a price which is more than the par value of bond, in case he calls away the bonds from the investors before the bonds reaches the date of its maturity.

The bond issuers will use the call feature , when the interest rate falls so that they can refinance the bonds now at a lower rate of interest. For example assume a 7% bond, callable after 5 years, if the interest rate falls to 5%, the issuer would call the bond and try to refinance it at a  lower rate of 5%. This leaves investors with reinvestment risk.

The investors price the bonds with a call feature as :

price of callable bond = price of straight bond – price of call option;

Callable bonds are available to investors at a lower price and at a higher yield as it does not favor the investors. Investors buy this security because in case the bond does not get called they can earn a higher interest till maturity which they would not have enjoyed in a non-callable bond although risks are attached with a callable bonds.


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