So… a heavy supply of new issue of bonds narrows the spreads and bonds appreciate even in the secondary markets - because traders can compare market prices.
And callable bonds command a premium due to their scarcity value.
WTF?
If there is a heavy supply of callable bonds, would the world end in a fiery crash as space and time collapse into a singularity?
is that a question or observation?
callable bonds dont command a premium to the buyer because it is an unattractive feature to them
Everything else equal, an increase in supply (moving the supply curve to the right) lowers the equilibrium price. This is Level I economics.
Everything else equal, a scarcity of a particular good (a decrease in supply, moving the supply curve to the left) raises the equilibrium price. Again, Level I econ.
Thus, a callable bond has a call option that will reduce its price, but if it’s scarce and people want callables, then the scarcity will increase its price. Whether the net effect will be that it sells at a discount or a premium (compared to a plentiful, option-free bond) depends on the relative magnitude of these two effects.
@S2000magician - I understand what you’re saying, but the effect of supply and demand on bond prices is presented differently in the text. During periods of heavy supply, the valuation of new issues “validates” the prices of outstanding bonds, thus narrowing spreads and increasing prices. This increased supply can give way to an increase in demand, and higher bond prices overall.
It does seem super confusing… but I think it might be better to think of these effects as two distinct issues based on the LOS: i. cyclical changes (supply & demand, more supply will actually mean higher bond price environment), and ii. secular changes (lack of callable bonds mean they will have a higher price because of scarcity value).
think about it from the company’s point of view. If you are a treasurer, when are you going to try to sell bonds – when markets are rocky and investors are scared, or when spreads are rallying and investors are happy? Obviously the second scenario is more appealing, you will be able to borrow more cheaply and you can be more certain of demand for your deal. So periods of heavy supply often coincide with narrowing spreads (even though this seems illogical).
If there’s too much supply, though, this can force spreads wider again (ie normal rules of demand and supply take over). i don’t think this is discussed in the CFA book, just mentioning it to help you make sense of the idea…
I reread the section on this LOS and saw that, although what I said is true, it didn’t go far enough. An increase in supply will lower the price, everything else being equal. However, the write-up says, explicitly, that _ everything else is not equal _: the increase in supply leads to an increase in demand (which will raise the equilibrium price), and the latter price effect will be greater than the former.
Yuck.
I agree that that’s a good plan: separate the effects.
Thanks Movingonup, that helps!