Question

True or false: If interest rates suddenly decline, those existing bonds that have a call feature are more likely to be called the issuer will pay the difference between the market value of bond and par value which is called the call premium. Please explain.

Answer 1

Yield to maturity and price of a bond have inverse relationship. In the sense, if yield falls, price of the bond would rise and if the yield rises, price of the bond would drop proportionately. So, if interest rates decline, price of bonds would increase. Bonds that are issued with a call feature give the buyer of bonds the right but not the obligation to buy the underlying at a predetermined par value even if the market value of bonds is higher. Thus, when the market is bullish, the bond is supposed to be trading at premium to its par value which is called " Call premium". Now instead of actually trading in underlying bond, the bond issuer would settle the difference amount between strike price & spot price which is nothing but the call premium and square off the position.