CFA Mock 2011 Afternoon Q 36
“Structural analysis of corporate bonds is a key part of our research process. Given Girona’s view that interest rates are in secular decline, we expect callable bonds to outperform bullets. In the event interest rates rise sharply, put structures will provide investors with some protection.”
Question: Is Statement most likely correct?
B is correct because callable bonds significantly underperform non-callable bonds when interest rates decline because of their negative convexity. When the bond market rallies, callable structures do not fully participate given the upper boundary imposed by call prices
My understanding: Per earlier thread: Bullet maturities work better under lower interest (Bear markets)
Put bonds cannot fully price when the interest rates are low (bullish market) as there is credit inherent that the issuer may fail to honour the liability. Hence puts suffer from higher implied yield/volatility in higher interest rate environment
If the rates are low, why the issuer be under a credit threat? If the rates rise, the creditor/investor will want to put the bond back to the issuer, and then issuer’s viabililty be in question.
My understanding: Per earlier thread: Bullet maturities work better under lower interest (Billish** markets)
Put bonds cannot fully price when the interest rates are **high** (bearish market) as there is credit inherent that the issuer may fail to honour the liability. Hence puts suffer from higher implied yield/volatility in higher interest rate environmen
Bullets are getting popular and replacing callable bonds.
Callable bond are scarce so they demand some premium as well.
Regarding performance, bullets are non-callable so their behaviour is attractive to callable’s in a low ir environment. imo. Id let someone add to this as appropriate
The callables allows issuers to take advantage of low rates by calling the bond. The investor than has to deal with the re-investment risk. The higher yield on the callable is a compensation to the investors for the re-investment riks.