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

Q1. Which of the following statements about callable bonds is TRUE?

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.

Q2. Price compression:

A)   reduces the potential for price appreciation.

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

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

Q3. 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.

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

Q1. Which of the following statements about callable bonds is TRUE?

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.

Correct answer is C)        

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.

Q2. Price compression:

A)   reduces the potential for price appreciation.

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

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

Correct answer is A)

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.

Q3. 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.

Correct answer is A)

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.

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