Got this wrong, and I think I know why, just want to see if this trips anyone else up… Which of the following statements does NOT accurately describe the relationship between callable bonds and bullet strategies? Callables: A) do not fully participate when bond markets rally due to the “resistance” level set by the call price. B) outperform bullets when rates increase due to positive convexity. C) outperform bullets in bear markets because the probability of an early call diminishes.
B
I agree with B. Callable bond = non-callable bond - option price change in callable bond = change in non-callable bond - change in option price option price is a monotonic function of interest rate.
I’d say A, although the use of the word “resistance level” makes me nervous. In a rally, though, the negative convexity does effectively set a limit on how high bond prices can go.
Your answer: C was incorrect. The correct answer was B) outperform bullets when rates increase due to positive convexity. Callable bonds: *Underperform bullets when rates decline due to their negative convexity. *Do not fully participate when bond markets rally due to the “resistance” level set by the call price. *Outperform bullets in bear markets because the probability of an early call diminishes. Okay… so for answer C I assumed that a bear market would imply lower rates, which would imply the callable bond is trading at a premium to to par yet not as much as a noncallable (negative convexity) which would make the noncallable outperform. I guess the assumption here is that a bear market does not imply lower interest rates, that we’re saying all else equal, the borrower would not be able to obtain funds to refi or there are no profitable investment opportunities or something? For answer B, shouldnt callable bonds offer a higher interest rate than noncallable and would therefore decrease in price less than bullets when rates rise?
Going with B Callables will not fully participate when bond markets rally, as interest rates will be decreasing and will provide issuers to call current issues and reissue at lower rates. Callables will outperform bullets in bear markets because interest rates are increasing and probability of an early call diminishes (though not totally sure what happens with bullets here).
PhillyBanker Wrote: ------------------------------------------------------- > Your answer: C was incorrect. The correct answer > was B) outperform bullets when rates increase due > to positive convexity. > > > Callable bonds: > > *Underperform bullets when rates decline due to > their negative convexity. > *Do not fully participate when bond markets rally > due to the “resistance” level set by the call > price. > *Outperform bullets in bear markets because the > probability of an early call diminishes. > > Okay… so for answer C I assumed that a bear > market would imply lower rates, which would imply > the callable bond is trading at a premium to to > par yet not as much as a noncallable (negative > convexity) which would make the noncallable > outperform. I guess the assumption here is that a > bear market does not imply lower interest rates, > that we’re saying all else equal, the borrower > would not be able to obtain funds to refi or there > are no profitable investment opportunities or > something? > > For answer B, shouldnt callable bonds offer a > higher interest rate than noncallable and would > therefore decrease in price less than bullets when > rates rise? When interest rates are rising, a callable bond behaves like a noncallable. The negative convexity only comes into play when interest rates are declining and issuers have an incentive to re-issue at lower rates. Also, to one of your points above: IMO when the question refers to bear markets it implies decreasing bond prices - increasing interest rates.
Magix, doesn’t what you just said seem like a contradiction? In both instances you are saying rates are rising, in one case you say that they both exhibit positive convexity and would thus perform the same (which makes sense) and the other you say increasing rates (bear market) cause the callable to outperform. I understand answer B, and the callable & bullet behaving the same due to positive convexity when rates rise, but not answer C.
That’s a good point. Even i’m not totally sure about the mechanics of the first half of point C (mentioned that in my answer above). Though, B is definitely wrong. Can anyone else shed light on why a callable bond outperforms a bullet in a bear market?
I think the key consideration is what constitutes a bear market. Typically I equate a bear market with declining stock prices, which imply lower interest rates going forward. But in context of the bear market for bonds, that implies interest rates are increase as bond prices are decreasing. But a bear market for bonds —> interest rates rise —> bond prices decline Both bonds act as non-callable bonds. However, since callable bonds are an attractive feature for the issuer, the issuer must compensate the lender in terms of a higher interest rate. All else equal, bonds that have higher coupon payments have a lower duration and are less sensitive to changes in interest rates. The callable bond will decrease in price at a lower rate than the non-callable due to a higher coupon payment (all else equal). Also you can maybe factor in that a bullet is more sensitive than a regular coupon pay bond with a similar maturity. Bullets pay at the end of the term.
That was my original reasoning for not selecting B as the choice, since I assumed that a callable bond would outperform a bullet due to the higher rate. However, schweser must assume the positive convexity feature will make both behave the same when rates are increasing. The question we want to know is why is C correct? Your answer just affirmed that both B and C scenarios should outperform bullets.
In scenario B, doesn’t a callable perform in line with/ or behave like a non-callable when rates are rising? could someone explains how it outperforms when both bonds display positive convexity? thanks.
Shot in the dark. It’s due to duration not convexity. The durations of the bonds are way different.
Is it because the callable would have been trading at a discount to the non-callable in the first place because of the option?? that must be it.
wow. i’m going to fail.
Tricky question. I would have gone with A and gotten it wrong. Go ahead and draw a callable bond and a price-interest rate chart of an otherwise identical straight (i.e. bullet) bond. One will be a sort of hyperbola, and the other (the callable) will have a kind of reverse S shape, where it intersects the Y-axis at the call value. Since the bonds are otherwise identical, the curves will not cross; however, as interest rates rise, the two curves will get closer and closer to each other, since they look pretty much like the same bond when the call provision looks unlikely to be exercised. The next step is to understand what a bear market means in bonds. That seems weird to us equity guys, because when stocks are having a bear market, the central bank usually cuts interest rates to make things easier to invest in, and, other things equal, that makes bond prices rise. So remember this: A BOND BEAR MARKET MEANS THAT BOND *PRICES* ARE FALLING. (I got this wrong earlier, and therefore haven’t forgotten it). Bond bull and bear markets don’t necessarily happen in sync with stock bull and bear markets. This is why bonds and stocks have good diversifying characteristics. You might think that they would be negatively correlated, which makes sense, except that when stocks are in trouble, credit spreads widen, so even if treasury rates go low, maybe borrowing rates don’t change much. OK, so now a bond bear market means that bond prices are going down, which implies that interest rates (RF + risk premia) are going up… Look at the chart you’ve drawn… for a given change in interest rates, which bond has dropped in value more? It’s the bullet portfolio. So given an increase in interest rates, the price of the callable drops less than the price of the bullet, which means it outperforms. Tricky question. There’s useful stuff to learn from it, but don’t freak out about getting too many questions like that.
Callable bond would need to have a higher interest rate all else equal to induce an investor to buy, therefore as rates rise, yes, the callable bond would exhibit positive convexity, and will also perform slightly better than the noncallable bullet bond since it will have a higher rate and therefore would have more cash flow and thus would have a slightly lower duration. Think about that like a Z bond and a mortgage; the z bond’s cash is entirely weighted towards maturity and would have a higher duration. I.E. schweser appears to be wrong here.
I think everyone wanted to now why Choice B was incorrect. Choice B and C both are scenario’s where interest rates rise and bond prices decline. What I was trying to state also (this was probably jumbled), a callable bond pays coupon payments, where bullet bonds (*** STRATEGIES ***) re-read the question. A bullet’s duration is centered on the bullet date. All else equal, the bullet strategies duration is higher than a callable issue with periodic coupon payments. (toss aside the fact that callables have to be issued with a higher coupon because of the option benefit to the issuer). They will have the same maturity, but a different distribution.
Both B and C appear correct based on my understanding.
I think that B is incorrect because callable bonds do not outperform bullets BECAUSE OF positive convexity, BUT because of the fact that the call option has no value anymore. Then yields need to be the almost the same for the two bonds - which leads to the callable decreasing less in value.