Lesson

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.

Practice Question #1

Which of the following is NOT a characteristic of a callable bond?

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Terms

Call feature:
A provision in a bond that allows the issuer to redeem the bond before its maturity date.
Callable bond:
A bond with a call feature.
Call price:
The price at which the issuer can redeem a callable bond.
Call date:
The date on which the issuer can redeem a callable bond.
Call protection:
The period during which the issuer cannot call a bond.
Call premium:
The amount above the par value the issuer must pay to redeem a callable bond.
Non-callable bond:
A bond without a call feature.
Yield-to-call:
The yield on a callable bond, assuming it is called on the first call date.
Yield-to-worst:
The lowest yield on a callable bond, considering all possible call dates and the maturity date.
Call risk:
The risk that a bond will be called, or redeemed, by the issuer before its maturity date.

Practice Question #2

What is the primary advantage of a call feature for the issuer of a bond?

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Do Not Confuse With

Put feature:
A provision in a bond that allows the bondholder to sell the bond back to the issuer before its maturity date.
Puttable bond:
A bond with a put feature.
Yield-to-put:
The yield on a puttable bond, assuming it is sold back to the issuer on the first put date.

Practice Question #3

What is the primary disadvantage of a call feature for the bondholder?

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Historical Example

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.

Practice Question #4

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Real-World Example

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.

Practice Question #5

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More Detail

- 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.

Practice Question #6

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More Detail Examples

- 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.

Practice Question #7

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Pitfalls to Remember

- Callable bonds pitfall:
Callable bonds may be less attractive to investors due to the uncertainty of the bond's maturity date and the potential for the issuer to redeem the bond when interest rates are lower, resulting in reinvestment risk for the bondholder.

Practice Question #8

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Practice Question #9

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