1. Why are many bonds callable? What is the disadvantage to the investor of a ca
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1. Why are many bonds callable? What is the disadvantage to the investor of a callable bond? What does the investor receive in exchange for a bond being callable? How are bond valuation calculations affected if bonds are callable? 1. Why are many bonds callable? What is the disadvantage to the investor of a callable bond? What does the investor receive in exchange for a bond being callable? How are bond valuation calculations affected if bonds are callable? 1. Why are many bonds callable? What is the disadvantage to the investor of a callable bond? What does the investor receive in exchange for a bond being callable? How are bond valuation calculations affected if bonds are callable?Explanation / Answer
Many bonds are callable because they give issuer the power to redeem the bond before maturity. Issuers call the bond before maturity when interest rates fall. This gives them the priviledge of refinancing by issuing bonds at lower coupons to reduce their debt costs. This is disadvantageous to the investors because the investors then have to reinvest their principal at lower interest rates. In exchange for calling the bond before maturity, the issuer buys back the bonds above par. Callable bonds also have slightly higher coupons than regular bonds to make them attractive to the investors.
Callable bonds are generally (not always) call protected for the first few years in investors' interest. When calling bonds, issuers pay a premium over par value known as call premium. This call premium starts to fall as term approaches maturity. In valuation of callable bonds, the maturity amount is not par value but a value greater than par value by an amount equal to call premium. For example it'll be 108% of par value if called in year 3, 107% if called in years 4, 105% if called in year 5, 103% if called in year 6 and 100% if called in year 7 for a term of 8 years.
Callable Bond Price = Summation ( Coupons/(1+ yield)t ) + Par Value * ( 100+ call premium)%/ (1+ yield)t
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