3.

i) Contrast the effect on the price of both bonds if yields decline more than 100 basis points. (No calculations required.) (5 marks)

If bond yields decline more than 100 basis points, the price of a straight bond will increase more than that of a similar bond with a call option. Callable bonds exhibit price compression as yields decline. As bond yields decline, interest payments become more uncertain as the likelihood that the issuer will call the bond increases. Therefore, upside price appreciation is limited. If bond yields decline more than 100 basis points, Callable Corp will recall the bonds because the debt could be refinanced at a lower interest rate. Please see the chart in the below:

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As one may observe, callable bond prices rise at a decreasing rate as yields decline and exhibit negative convexity (red line).

ii) State and explain under which future interest rate environments would the Callable Corp. bond be preferable to the Straight Corp. bond. (5 marks)

Through an investor’s perspective, the Callable Corp. bond would be preferable to the Straight Corp. bond during a stable or increasing interest rate environment. Callable Corp.’s bond pays a 4.25% coupon payment versus Straight Corp’s 4.00% coupon bond. This is not a surprise because issuers will pay a slightly higher interest rate than would be necessary for a similar straight bond to compensate for uncertainty (prepayment risk). Therefore, if interest rates remain the same or increase, investors will receive the benefit of a higher than normal interest rate throughout the life of the bond because Callable Corp. would never have the opportunity to recall the bond and re-issue debt at a lower rate.

iii) State the directional price change, if any, assuming interest rate volatility decreases, of each of the two bonds under