Call features of fixed-income securities allow the bond issuer to redeem or "call" the bond before its maturity date. This can be advantageous for the issuer if interest rates have fallen since the bond was issued, as they can refinance their debt at a lower cost. However, this can disadvantage the bondholder, as they may have to reinvest their funds at a lower interest rate.
Which of the following is NOT a characteristic of a callable bond?
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A) Call protection is when the issuer cannot call a bond. B) Call premium is the amount above the par value the issuer must pay to redeem a callable bond. C) Yield-to-call is the yield on a callable bond, assuming it is called on the first call date. D) Put feature is a provision in a bond that allows the bondholder to sell the bond back to the issuer before its maturity date and is not a characteristic of a callable bond.
What is the primary advantage of a call feature for the issuer of a bond?
A) The primary advantage of a call feature for the issuer is the ability to refinance debt at a lower interest rate if interest rates have fallen since the bond was issued. B) A call feature does not allow the issuer to extend the bond's maturity date. C) A call feature does not allow the issuer to increase the interest rate on the bond. D) A call feature does not directly affect the issuer's ability to sell more bonds in the future.
What is the primary disadvantage of a call feature for the bondholder?
A) The primary disadvantage of a call feature for the bondholder is the risk of reinvesting their funds at a lower interest rate if the bond is called. B) Callable bonds are typically called at a price that includes a call premium, not a lower price. C) A call feature does not directly affect the bond's credit rating. D) While a call feature can affect the bond's market price, the primary disadvantage for the bondholder is the risk of reinvesting funds at a lower interest rate.
In the early 2000s, a large corporation issued callable bonds with a high interest rate. As interest rates fell over the next few years, the corporation called the bonds and refinanced its debt at a lower interest rate. This move saved the corporation millions of dollars in interest payments but left bondholders with lower returns as they had to reinvest their funds at the prevailing lower interest rates.
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Example Series 65 Example Practice Question
A city issues callable bonds to finance the construction of a new bridge. The bonds have a 10-year maturity and a 5% interest rate. After five years, interest rates have fallen to 3%. The city decides to call the bonds and issue new bonds at the lower interest rate, saving taxpayers money on interest payments.
- Callable bonds: A type of bond that allows the issuer to redeem the bond before its maturity date, usually at a specified call price. - Call features: The terms and conditions that govern the issuer's right to call or redeem a bond before its maturity date. - Call premium: The amount above the bond's par value that the issuer pays to bondholders when redeeming a callable bond early.
- Callable bonds example: A corporation issues a 10-year bond with a 5% coupon rate and a call feature that allows the issuer to redeem the bond after 5 years at a call price of 105% of the par value. - Call features example: The call feature in the above example allows the issuer to redeem the bond after 5 years, but not before, and at a call price of 105% of the par value. - Call premium example: In the above example, the call premium is 5% (105% - 100%) of the par value, which the issuer pays to bondholders when redeeming the bond early.