I dont quite understand why a party (issuer or holder) would want to introduce options because it only benefits one side of the party correct? It says in the text that Call options are beneficial to issuers, so why would anyone buy a bond that has call option? Can someone kindly explain to me please? THanks
Because they usually have a higher yield than the ones without call feature
^Exactly. The issuer pays an option premium in the form of a higher spread. The reverse is true for a puttable bond. The investor/lender is paying for the option by accepting a lower spread.
YMC and TMurf are correct. If a buyer buys a security that has an option against them, they will command and deserve compensation for that. Now, the question still remains as WHY they would do that? There are a variety of reasons, one reason is that buyers do not think that the market conditions will change to make the option exercisible. Imagine that I buy a callable bond. I think that interest rates will not drop significantly to make refinancing seem attractive. Hey, I might even think they’re going to increase. If I’m right, then I got a premium for letting the poor guy who issued it say that his has a right not an obligation to buy the bonds early. If I’m wrong, the options will be exercised. The same goes for other securities. Buyers don’t think market conditions will change enough for the option to be exercised. Sellers have reason to believe that the option will could be worth a lot more than the premium.
Nah. If you think that “interest rates will not drop significantly to make refinancing seem attractive” then you don’t make bets by investing huge amounts in a bond and get a small amount by selling the embedded option. You make direct interest rate bets. In any event, selling an option is selling volatility. BTW - If you think interest rates will not drop significantly, then you also think you will not make significant money on this bond (other than credit issues). Perhaps you need to think of some other way to be investing where you think you might have some upside? The reason that people buy callable corporate debt is that there just isn’t much non-callable corporate debt out there. You don’t like the call feature, you don’t buy the bonds (or you hedge the call risk). The other part of this - a sort-of behavioral finance thing - is that issuers think that call options embedded in bonds are worth more than they actually are by any reasonable modelling technique. People just can’t sleep at night knowing that they can’t refinance their debt so they are willing to buy the call options for more than they are worth. For the corporate bond buyer that means that you get paid an amount incommensurate with the risk you are taking. So to mirror the question above “why would anyone buy a bond that has call option?” - “why wouldn’t everyone buy callable corporate debt when they are getting paid an incommensurate amount for the risk they are taking?” Of course, there are good answers for that too. Of course, if you are big enough you can use CDS and swaptions to hedge your exposure to call risk and make it go away.
alsa0044 Wrote: -------------------------------------------------------> > Imagine that I buy a callable bond. I think that > interest rates will not drop significantly to make > refinancing seem attractive. Hey, I might even > think they’re going to increase. If I’m right, > then I got a premium for letting the poor guy who > issued it say that his has a right not an > obligation to buy the bonds early. If I’m wrong, > the options will be exercised. > Read that paragraph again and then imagine walking into your bosses office and telling him how proud you were that you were right that interest rates were going up and you are very happy that they will not call the corporate bonds you bought. The best you can hope for is a “Whaaa?”
Ohh man, thanks for catching my blunder Joey. I obviously have a long way to go before december…sorry for the incorrect answer. Looks like it is back to stealth mode for me until I beef up.
Hmm…thanks for that Joey. Got my brain juices flowing a bit thinking about what you just said here. Being able to successfully hedge off that option risk and receive the higher premium/yield for the callable debt is a nice strategy. I imagine that is how it is done more or less by the big players… especially in that, from what I have seen, many corp bonds seem to be using call options on new debt securities. I imagine a problem with a strategy like that might be if buyer were leveraged into the callable bond and then if interest rates dropped to make the call more likely, then (buyer) may be fine on the hedged i/r side but may be in trouble on finding an equivilant (= risk) debt instrument for their required r/r considering their leveraged-capital rate. ?? Or would one hedge both directions…hedge for call option…and hedge for the i/r (increase) risk…just curious.
Hedging call options on bo9nds is tough for the bond buyer because you have to deal with both credit and inteerst rate issues. As you say, there are lots of traps and it really can only be done in big size.