Stalla says: “…Typically, issuers pay an annual spread premium of 30-40bp to entice investors to buy callable bonds. As would be expected, callables underperform bullets in periods of declining interest rates due to the higher risk of call (negative convexity). IN BEAR MARKETS, CALLABLES OFTEN OUTPERFORM as they have little risk of being called and they pay a spread premium.” Question: Why would callables outperform in bear markets. Don’t interest rates generally decline in bear markets? And if they were to decline, wouldn’t there be a high incentive to refinance at lower rates in order to free up cashflow? This seems odd to me, can someone else help clarify?
by issuing callables you are selling a call option… when int rates increase that option is OTM to whoever bought the bond… so that option premium will enhance the value over noncallables…
I guess it depends on how you define a bear market. In terms of fixed income, I would think a bear market is when rates increase since it is bad for bond prices. In rising rates, callables outperform non-callables, at least until rates get so high that the call option is worthless. At this point, callables and non-callables act the same.
Shouldn’t that say BULL markets…assuming in bull markets rates are increasing. And when rates are increasing don’t Callables slightly outperform non callables because of the negative convexity effect out to a certain point (coupon rate) where the two behave the same?
Bear market for bond is when prices go down and int rates go up. As int rates go down, callables outperform non-callables due to negative conveixty. Beyond coupon rate, they behave as non-callables.
As int rates go down, callables outperform non-callables due to negative conveixty. Beyond coupon rate, they behave as non-callables. ^ think it is reversed… for neg. conv… when rates decrease the value increase is less than non callables…
OK, if it is a bond bear market and rates are rising, then I definitely agree… the hit you take from negative convexity in a falling rate environment is reversed, and you outperform in a rising interest rate environment. If that is what a bear market means, I’m ok with that, but it wasn’t clear to me. I interpreted a bear market as companies not performing well, equities getting pummeled, etc… i.e. the usual sense of the word. Anyone else have the CFAI books with them (I’m travelling and only have my Stalla stuff with me).
Totally Reversed.
Yeah, I see that point if the question specifically points you in that direction. When someone says BULL market I just assume the markets as a whole where rates are increasing, stock prices are increasing, employment is good…ect… Usually when someone mentions Bull market I just take for granted (generally speaking) bond prices will be falling.
sorry - was reversed… my mistake. int rates go up, callables outperform non-callables (decreases at lower rate than non-callable due to neg convexity). Once greater than coupon rate, then behaves as a non-callable.
quit abusing convexity. you guys are killing me. negative convexity is always bad for the holder. you always want positive convexity as a holder. the reason the callable bond rises more can be explained by 1) bond - option method (3rd and Long nailed this one) 2) premium/discount… because you hold a callable bond, they will trade at a discount to noncallable bonds, as interest rates rise, then this discount approaches --> zero.
The price of a callable is always less than a straight bond, but outperforming means the following. 1) Day one, you put $100 in Bond A (straight) and $100 in Bond C (otherwise identical, but callable). 2) Now the price of a single Bond C is less than the price of a single Bond A because you’ve sold an option and negative convexity is bad. However, that doesn’t matter so much because you are putting the same amount of money into each bond… This is equivalent to saying that the fact that Stock C is priced lower than Stock A doesn’t mean it’s any more or less of a value. 3) Day two, interest rates shoot up 100 bps. OMG!!! Both bonds drop in value, but the portfolio with bond C in it doesn’t drop by as much. Now if you are an investor interested in absolute returns, it’s bad either way, but if you are trying to beat a benchmark without callables in it, then the portfolio with Bond C did well. Or if you did relative value trades, and sold Bond A in order to buy Bond C, you did well. In this way, Bond C outperformed Bond A in a (bond) bear market. So I guess it’s just important to remember that bond bear markets are when interest rates go up, which is usually a stock bull market.
MFE Wrote: ------------------------------------------------------- > quit abusing convexity. you guys are killing me. > negative convexity is always bad for the holder. > you always want positive convexity as a holder. > the reason the callable bond rises more can be > explained by > > 1) bond - option method (3rd and Long nailed this > one) > > 2) premium/discount… because you hold a callable > bond, they will trade at a discount to noncallable > bonds, as interest rates rise, then this discount > approaches --> zero. yeah basically as IR increase option value drops so Callable outperforms
comp_sci_kid Wrote: ------------------------------------------------------- > MFE Wrote: > -------------------------------------------------- > ----- > > quit abusing convexity. you guys are killing > me. > > negative convexity is always bad for the holder. > > > you always want positive convexity as a holder. > > > the reason the callable bond rises more can be > > explained by > > > > 1) bond - option method (3rd and Long nailed > this > > one) > > > > 2) premium/discount… because you hold a > callable > > bond, they will trade at a discount to > noncallable > > bonds, as interest rates rise, then this > discount > > approaches --> zero. > > yeah basically as IR increase option value drops > so Callable outperforms and yes, negative convexity always bad
bchadwick Wrote: ------------------------------------------------------- > So I guess it’s just important to remember that > bond bear markets are when interest rates go up, > which is usually a stock bull market. Why is that ? I mean why is it a stock bull market when interest rates go up ? Rise in interest rates => Higher expected returns => lower valuations. Right ? Isn’t a rise in interest rates a Fed measure to tighten monetary policy to control high inflation and high growth ? But, a rise in Fed interest rates in not usually good for stocks, no ?
fsa-sucker Wrote: ------------------------------------------------------- > bchadwick Wrote: > -------------------------------------------------- > ----- > > So I guess it’s just important to remember that > > bond bear markets are when interest rates go > up, > > which is usually a stock bull market. > > Why is that ? I mean why is it a stock bull market > when interest rates go up ? Rise in interest rates > => Higher expected returns => lower valuations. > Right ? > > Isn’t a rise in interest rates a Fed measure to > tighten monetary policy to control high inflation > and high growth ? But, a rise in Fed interest > rates in not usually good for stocks, no ? rates rise when there is an economic growth
comp_sci_kid Wrote: ------------------------------------------------------- > fsa-sucker Wrote: > -------------------------------------------------- > ----- > > bchadwick Wrote: > > > -------------------------------------------------- > > > ----- > > > So I guess it’s just important to remember > that > > > bond bear markets are when interest rates go > > up, > > > which is usually a stock bull market. > > > > Why is that ? I mean why is it a stock bull > market > > when interest rates go up ? Rise in interest > rates > > => Higher expected returns => lower valuations. > > Right ? > > > > Isn’t a rise in interest rates a Fed measure to > > tighten monetary policy to control high > inflation > > and high growth ? But, a rise in Fed interest > > rates in not usually good for stocks, no ? > > rates rise when there is an economic growth yes. that’s what I mean. Rates rise in response to economic growth and not the other way around.
Central banks typically raise interest rates during a bull market to try to prevent overheating of the economy and to stave off inflation. Also to make sure that they have some ammunition to use if the economy starts to falter - it’s hard to cut interest rates below 0 without having helicopters. Credit spreads might narrow in a bull market, I’d think, since cash flows are more likely to cover interest payments, but most central banks will usually try to raise interest rates.