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LOS h: Explain the disadvantages of a callable or prepayable security to an investor.

Simone Girau holds a callable bond and Chi Rigazio holds a putable bond. Which of the following statements about the two investors is most accurate?

A)	As the yield volatility increases, the value of both Girau's bond and the underlying option increases.

B)	Girau's bond has less potential for price appreciation.

C)	Both investors calculate the value of the bond held by adding the value of the option to the value of a similar straight bond.

When a bond has a call provision, the potential for price appreciation is reduced, because the call caps the price of the bond near the call price. Even if interest rates fall considerably, it is unlikely that investors would pay a price that exceeds the call price.

The other statements are false. To calculate the value of a putable bond, it is correct to add the option value to the value of a similar straight bond. However, to calculate the callable bond value, subtract the option value from that of a similar straight bond. As a result, when yield volatility increases (thus increasing the option value), the value of a callable bond decreases and the value of a putable bond increases. A call option does benefit the issuer, but a put option benefits the holder. Embedded options (puts and calls) increase in value when volatility increases.

A)	As interest rates fall, the value of a callable bond will exceed that of a similar straight bond.

B)	As interest rates decrease, the value to the investor of the call option increases.

C)	When yields rise, the value of a callable bond is less sensitive and will exhibit less of a price change than a noncallable bond.

When yields rise, the value of callable bond may not fall as much as that of a similar straight bond because of the embedded call option feature. With a decrease in interest rates, the value of a callable bond can increase to only approximately the call value (the call price serves as a cap or “ceiling.”). Straight bonds will continue to exhibit the inverse relationship between yields and prices, as there is no “ceiling” call price.

The statement that begins, “As interest rates decrease…,” should continue, “.. the value to the issuer of the call option increases.” As interest rates decrease, the issuer values the call option more because the company has the potential to call the bond and replace existing debt with lower-coupon (and thus lower cost) debt.

A)	occurs when a bond's cap and floor are set close together.

B)	reduces the potential for price appreciation.

C)	occurs when demand for a bond is high near the first call date.

When a bond has a call provision, the potential for price appreciation is reduced, because the call caps the price of the bond near the call price, even if interest rates fall considerably. It is unlikely that investors would pay a price that exceeds the call price.

Which of the following statements is FALSE? Compared to a callable bond, a noncallable bond:

A)	provides a higher yield.

B)	is more attractive to an investor concerned with reinvestment risk.

C)	has more predictable cash flows.

When compared to a callable bond, the yield on a noncallable bond is less. With a noncallable bond, the issuer does not have to compensate the investor for call risk/cash flow uncertainty with any premium. The other choices are true. Call risk is the combination of cash flow uncertainty and reinvestment risk. When a bond is called, the investor faces a disruption in cash flow and a reduced rate of return.