i’ve now seen in a few different places the concept that bonds with embedded options command premiums due to their scarcity (outside of the HY market). totally understand this for putable bonds but why would a callable bond ever demand a premium - the value of the bond is the bond price less the value of the option, which never has a negative value (either it’s worth 0 if rates are high or is worth something when rates are low). any insight is appreciated
Thought this was on level 2…when you buy a callable bond you also short the call option on the bond. Value of a callable bond is bond - option value… as vol goes up option has more value so bond goes down
right, so i would expect the callable bond to always garner a lower price than a non-callable, except in a very high interest rate environment. so, back to my original question, how could a callable bond ever command a premium? the option value would have to be <0
My real world perspective is that callable bonds certainly are not rare, but I guess scarcity is sometimes an issue in pricing. The justification is that callable bonds tend to trade a little above their fair value, on average in some market conditions. For instance right now, with an upward sloping yield curve investors tend to be willing to pay for a callable with a negative OAS, i.e. they are overpaying slightly. So lets say bond is worth 100 without call option (bullet) and the yield is 4%. With call option its worth 98 and a yield of 4.5%. So the value of the call is 50 bps and 2 points. Investor might actually pay 98.5 for it, meaning the buyer is not fully compensated for the value of the call. As a real world example, this week agency bonds were trading at basically the same yield as a bullet, because investors needed exposure to the call structure (hedging mortgage risks?). So investors were willing to buy a 3 year callable with the same yield as a bullet, even though the callable is short a call and are clearly not being compensated.
ridgefield Wrote: ------------------------------------------------------- > right, so i would expect the callable bond to > always garner a lower price than a non-callable, > except in a very high interest rate environment. > > so, back to my original question, how could a > callable bond ever command a premium? the option > value would have to be <0 I think premium in the sense of relative to intrinsic value.
On the same subject, could someone confirm that in a highly volatile environment if rates fall but are far from the call strike an MBS’s total return will remain higher than a corporate bond because: - The corporate bond’s yield increase will be less than its drop in price. - The MBS call value increases because of volatility which increases the MBS price (??? WHY - if the call value increases, this is a disadvantage to the investor no???) More specifically I’m trying to understand why: " a small drop in treasury rates combined with increased volatility will provide positive outcomes for MBS holders" My logic is: MBS has negative convexity, therefore rate drop doesn’t profit as much for MBS than for corp bond. Furthermore, MBS has call option. Higher volatility = higher call option value = detriment to the investor. I know we’ve adressed this before on the forum, but I still can’t wrap my head around this. Can anyone help me out on this one… Thanks! J.
Callable bond has a premium associated it with because the issuer has the right to buy back the bond. The buyer of the bond has essentially sold the issuer a call option on the bond. In general I believe the point is ABS/MBS provide a little more yield than bonds in general. So even when interest rates drop the MBS will probably trade at a premium to a non callable corporate bond.
When interest rates fall and volatility rises, MBS issuers benefit from it… MBS investors suffer from it… MBS issuers essentially buy a call option (take advantage when interest rates fall (exercise the option) and refinance their mortgages), so they pay a premium over non-callable bonds…