Manager positions the portfolio to reflect the firm’s opinions on the direction of interest rate & credit spreads. Over the next six months, manager is forecasting
low & stable implied interest rate volatility
spreads to narrow in all spread sectors
a positively sloped yield curve with short rates rising 25 bps & long rates rising by 75 bps
Given manager’s int rate volatility & YC forecasts in above statement, compared to bullet structures, callables & putables respectively will most likely:
callable will fall less than the regular bond … so it will outperform.
with a rising interest rate - there is every chance that the bond can be put back to issuer at par - and hence earn more.??
If int rate are increasing, call option is out of money. So callable will behave like a positive convexity bond (regular bond)…Is in it?. How to do you discern that it will fall less??
look at the MBS structure - MBS is also callable. on the right side - when rates fall -> the fall is less for a MBS than it is for a regular bond.
for a putable bond - when rate rises - there is a higher chance of the investor putting back the bond to the issuer. When that is done - instead of getting the lower price (return) that is now available - he will at least get the par value of the bond back. [Usually put to par]. So that will increase the investor’s value when compared to holding the “falling price” bond.
that was my logic … maybe I am wrong.
Pg 81… textbook
Callables significantly underperform bullets when interest rates decline because of their negative convexity. When the bond market rallies, callable structures do not fully partic- ipate given the upper boundary imposed by call prices. Conversely, callable structures outperform bullets in bear bond markets as the probability of early call diminishes.
Pg 82:
In the case of a putable bond, the implied volatility can be obtained using a valuation model such as the binomial model. The implied volatility should be the same for both puts and calls, all factors constant. Yet, for putable structures, implied volatility has ranged between 4%–9% since 1990, well below the 10%–20% volatility range associated with callable structures for the same time period. This divergence in implied volatility between callables (high) and putables (low) suggests that asset managers, often driven by a desire to boost portfolio yield, underpay issuers for the right to put a debt security back to the issuer under specified circumstances. In other words, the typical put bond should trade at a lower yield in the market than is commonly the case.
Unless put origination increases sharply, allowing for greater liquidity and the creation of more standardized trading conventions for this rarer structural issue, this asymmetry in implied volatility between putable and corporate structures will persist. Meanwhile, this structure should be favored as an outperformance vehicle only by those investors with a decidedly bearish outlook for interest rates.
