Quick question for the community as this has been driving me insane. Comparing callable and non-callable bonds when interest rates go up or down.
My logic was as follows:
The value of a callable bond = Value of the straight bond - the value of the call option (as it benefits the issuer/borrower)
If interest rates rise, the value of the straight bond would drop and the value of the call option would rise. This implies that the callable bond would underperform the straight bond because of the appreciation in the call option. The opposite logic should therefore be true for a drop in interest rates. The straight bond would increase and the call option would drop, thereby allowing the callable bond to outperform…
My issue arises when I attempt Q3B from the 2015 mock exam: The answer reads:
A_s credit spreads narrow and yields experience a downward parallel shift, corporate callable bonds trading at par underperform corporate non-callable bonds of the same maturity and credit quality. This occurs because callable bonds have shorter duration, lower (possibly negative) convexity and higher probability of call exercise._
So clearly my logic is off somewhere. If someone could please set me straight that would be much appreciated!