Confusion: Interest rate cap vs Bonds with embedded call options

CFA Level II
#1

Hi everyone,

Could someone please help me clear up some confusion with how interest rate caps and call options in bonds work?

As far as I understand, an interest rate cap has a payoff when interest rates rise above the cap rate, thus allowing the investor (or was it the issuer…?) to hedge against expected rise in interest rates which cause them to have a lower bond value.

The embedded call options in bonds is for the issuer to “call back” the bond when interest rates fall and the price of the bond goes ABOVE the strike rate. The issuer does this due to: 1) not wanting to pay the investor a higher bond value in the situation the investor wants to sell back the bond to the issuer. 2) The drop in interest rates will allow the issuer to refinance the bond at lower rates by calling the bond early before it matures.

Is my logic correct in this way of thinking? Please help correct me if I’m wrong, I’m really struggling to conceptualize these two concepts.

Thanks

#2

Interest rate caps and floors are for floating bonds, in which case the coupons are not fixed. A cap fixes the maximum that a bond issuer will pay, so a cap is an asset to the issuer.

Callable bonds are fixed coupon bonds. So if rates go down, the issuer realizes he she can call back the bond and issue another bond with a cheaper coupon.

#3

Thanks for the explanation. I actually found what i was looking for in reading 51 with the chart about options on rates vs options on prices (on fixed income securities).

It makes a lot of sense now that you explained how the cap/calloption is an asset to the issuer. To clarify, the issuer simply does not want to pay higher periodic payments, is that correct?

-The interest rate cap allows the issuer to continue paying a lower payment when interest rates increase.

-The embedded call option on the bond allows the issuer to simply re-issue the bond in case the floating interest rate rises, to prevent them from having to pay the investor higher coupon payments.

#4

All correct except this one. I think you get the idea but you have to appreciate that the coupons are not floating. The bonds are not floating rate bonds.

Let’s do this exercise. Imagine you issue a bond with 4% fixed coupon , at a time when the market rates are 4%. What is the price of the bond?

  1. It is priced at par. Now imagine next day interest rates drop to 1%. What will be the price of your bond? It will increase. Say 110 (without any calculations). Note what happened.

Yesterday you issued a bond and received 100 cash for your projects. Today you can call back that bond, pay back the 100 to the investor, and issue another bond with a f ixed coupon of 1%. What will be the price?

  1. It will be priced at par again. You can go ahead with your project as planned, but now you are not contractually obliged to pay 4% coupons, only 1%.

Tomorrow if interest rates shoot up to 10% you will ignore it. Let other issuers pay 10%, your contract says you will pay 1%…

#5

So if the interest rates drop to 1% and the price increases to 110, does this mean that if the bond reaches maturity, the issuer must pay back $110 and $4 coupon (since originally it was fixed coupon)? or are you saying that I can reissue a new bond at 1% fixed coupon at bond price of $110?

My confusion with the call is that, I understand that I will pay back the original par value. However, if I called back the bond, do I still owe a coupon rate to the original investor?

For the most part, I have no problem solving these types of problems since I have this understanding of how the numbers/formula works, but I really want to understand it conceptually.

#6

At maturity issuer will pay 100+4, which is the generic form of cash flow of bonds at maturity (Principal+last coupon). The key is that given the price of 110 the issuer will not wait till maturity but will instead call the bond, return back the 100 plus any accrued coupon and part ways with the investor. In other words the investor will be denied the chance to continue receiving coupons of $4 every year.

If the investor wants to receive coupons of 4% in an economy where yields are 1% he she will have to pay a premium for such bonds. That is why when issuers have the embedded option they will call the bond and say to the investor:

  • Rates have changed mate. If you want the same bond you have to pay me 110 now, receive your annual 4% coupons, and I will give you 100 upon maturity. Or, if you want, pay me 100 now, I will pay you coupons of 1% (instead of 4%) plus 100 on maturity.

Note that if there was no call option the issuer would be stuck with the bond and would have to pay 4% no matter how interest rates move (either favorably or adversely).

#7

Caps and Floors needn’t be necessary for floaters but are preferable as a hedge against floaters. For ex: ABC can issue a 10y fixed bond callable after 5yrs/even non callable and say a year later the environment for a falling rate comes up unfortunately. ABC could hedge this buying a floor or selling a cap to generate excess returns. In the event that they expect rates to rise, they could buy a cap not as a hedge but to make more money if rates eventually go up.

#8

Thank you for your explanations. It makes a lot more sense now.