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FRM Part I · FRM Exam Part I · Corporate Bonds

A corporation issues a bond with a clause that lets the issuer redeem the bonds before maturity at a pre-specified price. Relative to an otherwise identical non-callable bond, which statement is correct from the investor's perspective?

A callable bond should offer a higher yield than a comparable non-callable bond. The issuer owns the call option, so investors accept capped price gains and reinvestment risk when rates fall, and they require extra yield as compensation for being short that option.

  1. AThe callable bond should offer a higher yield because the investor bears reinvestment risk and limited price appreciationCorrect
  2. BThe callable bond should offer a lower yield because the issuer holds an option that reduces its funding cost
  3. CThe callable bond has the same yield because the call price is fixed in advance
  4. DThe callable bond has negative convexity only when the bond trades at a discount to par

Explanation

The call option belongs to the issuer, so the investor is short that option and must be compensated with a higher yield. Price appreciation is capped near the call price when rates fall, and the investor faces reinvestment risk. The lower-yield option reverses who owns the option.

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