Question

Discuss in detail the impact of call option features on bonds. You are required to show an excellent understanding of why firms issue callable bonds, why they are attractive to investors and the risk that the callable bondholders may face.

Word count required: 300-350 words

Answer 1

Call option is an option available to the issuer whereby they can call back the bonds after a certain period at a pre-specified price.

For example, an issuer raised $100m by issuing 1 million bonds at $100 at 5% coupon rate with 10 year maturity. After 5 years, the interest rate declined and the same bond is available at a yield of 2%. Now even though the current interest rate is 2%, interest paid by the issuer is still 5% (coupon rate). Had they issued the bond with a call option, they can buy the bond back by paying $100m to bondholders and reissue them at 2% and reduce the cost of borrowing.

The risk to the bondholders with callable bonds is that they will get the capital back when the interest rates are low. Hence, they would need to invest the sum at a lower interest rate then the coupon rate they were earning from the bond earlier, which is known as the reinvestment risk.