Siegel, Inc. has issued bonds maturing in 15 years but callable at any time after the first 8 years. The bonds have a coupon rate of 6%, and are currently trading at
$992 per $ 1,000 par value. If interest rates decline over the next few years:
Click on the arrows to vote for the correct answer
A. B. C.Explanation
When a bond is callable, it means that the issuer has the right to redeem or "call" the bond before its maturity date. In this case, Siegel, Inc. has issued bonds that mature in 15 years but can be called at any time after the first 8 years.
The price of a bond is influenced by various factors, including interest rates and embedded options. In this scenario, if interest rates decline over the next few years, it would generally have two main effects on the bond:
Impact on the price of the bond: When interest rates decline, the price of existing bonds typically increases. This is because the fixed coupon payment of the bond becomes more attractive relative to the lower prevailing interest rates in the market. As a result, investors are willing to pay a higher price for the bond to capture its higher yield compared to newly issued bonds with lower coupon rates. Therefore, the price of the bond is expected to increase.
Impact on the call option: The call option embedded in the bonds allows the issuer (Siegel, Inc.) to redeem the bonds before their maturity. When interest rates decline, the value of the call option typically increases. This is because lower interest rates make it more favorable for the issuer to refinance the bond at a lower cost, potentially leading them to exercise the call option and redeem the bond. As a result, the call option becomes more valuable to the issuer.
Now, let's analyze the answer choices provided:
A. The call option embedded in the bonds will increase in value, but the price of the bond will decrease. This answer is incorrect because it suggests that the price of the bond will decrease. However, as explained earlier, when interest rates decline, the price of the bond generally increases.
B. The price of the bond will increase, but probably by less than a comparable bond with no embedded option. This answer is partially correct. When interest rates decline, the price of the bond is expected to increase. However, the presence of the call option tends to limit the potential increase in price compared to a similar bond without the embedded option. This is because the call option provides the issuer with the ability to redeem the bond, which reduces its attractiveness to investors and can cap the potential price appreciation.
C. The price of the bond will increase, primarily as a result of the increasing value of the call option. This answer is incorrect. While the value of the call option does increase when interest rates decline, it is not the primary driver of the increase in the price of the bond. The primary driver is the decline in interest rates, which makes the fixed coupon payment of the bond more attractive and increases its market value.
In summary, the correct answer is B. The price of the bond will increase, but probably by less than a comparable bond with no embedded option.