Callable Bond vs. Noncallable Bond: Impact of Interest Rate Changes

Callable Bond vs. Noncallable Bond

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Question

Allison Coleman, CFA, owns a bond portfolio that includes Bond X, a callable bond with ten years to maturity that is callable at any time beginning one year from today. Coleman's portfolio also includes Bond Y, a noncallable security with ten years to maturity that carries the same credit rating as Bond X. Coleman expects interest rates to drift steadily lower over the next few years. Based on this assumption, Coleman should expect that:

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A. B. C.

C

Let's analyze each answer choice and determine which one is correct based on the given information.

A. Bond Y will experience a larger decrease in value than Bond X. This answer choice is incorrect. Since Coleman expects interest rates to drift steadily lower over the next few years, bond prices generally increase when interest rates decline. However, this relationship applies to callable and noncallable bonds alike. Therefore, there is no reason to expect Bond Y to experience a larger decrease in value compared to Bond X solely based on the interest rate outlook.

B. Bond X will benefit from positive convexity as rates decline. This answer choice is incorrect. Positive convexity refers to the relationship between bond prices and interest rates. Bonds with positive convexity experience larger price increases as interest rates decline, and smaller price decreases as interest rates rise. Callable bonds, such as Bond X, generally have negative convexity. When interest rates decline, the likelihood of the issuer calling the bond and refinancing at a lower interest rate increases. This call feature limits the potential price appreciation of the bond, reducing its convexity. Therefore, Bond X is not expected to benefit from positive convexity as rates decline.

C. The option embedded in Bond X will increase in value. This answer choice is correct. Bond X is described as a callable bond, which means the issuer has the right to call back or redeem the bond before its maturity date. This call option is embedded in the bond. When interest rates decline, the value of the call option embedded in a callable bond increases. This is because lower interest rates make it more attractive for the issuer to call back the bond and refinance at a lower cost. As a result, the call option in Bond X is expected to increase in value as interest rates drift steadily lower, providing a potential benefit for the issuer.

In summary, the correct answer is C. The option embedded in Bond X will increase in value.

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