Why would a bond with a call option trade at a premium?

LOS 29b: It says that due to the fact most bonds are intermediate term bullets, bonds with embedded options will trade at premium prices due to their scarcity value. If a bond is callable, then wouldn’t it trade for a discount vs. a noncallable bond, since it carries with it the threat of being called away if interest rates decline? Why would an investor pay a premium just because its scarce?

Based on secular analysis there may be a small premium embedded in the price (for the scarcity value), however, the overall option’s effect would depend on valuation factors such as volatility that would most likely outweight any scarcity premium, so it would still probably trade at a discount to an otherwise identical non-callable bond. I think that it is just saying that the actual price may not purely reflect the valuation fundamentals because of the scarcity value based on demand. That’s how I interpreted it anyway.

If it was a putable bond this would make sense.

Bonds with embedded options (so both callable and putable) trade at premium prices because of their scare value. There aren’t many around. Callable because offer higher premium that option-free and putable because offer the holder the right to put the bond back to the issuer.

the issuer provide extra benefit for the callable feature so that the bond can be sold. Because of callable bond is scarce, this kind of extra benefit is scarce. The premium is for the extra benefit to achieve a premium. But as DFWAnalyst said, it may not change the fundermental characteristics of the callable bond(discount, callable). the premium is based on the price which is already at discount.

puttable bonds are clear why they trade at a premium callable bonds pay higher coupon rates to compensate investor for probability the bond will be called when interest rates fall ( reinvestment risk) …these bonds are scarce in the market place…if for whatever reason the investor feels that the issuer will not call ( does not have sufficient funds etc) the bonds will trade at a premium…

pimpineasy,, the premium you referred may not be the premium for scarcity. actually, if the investor feels the call is less likely, the premium does exist no matter whether the callable bond is scarce. Charles