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IAI Actuarial Core Principles · Business Finance · Financial instruments issued or used by companies

Which of the following statements about a bond with a call option held by the issuer (a callable bond) compared with an otherwise identical non-callable bond is correct?

A callable bond usually offers a higher yield than an equivalent non-callable bond. The issuer can redeem early when interest rates fall, capping the holder's gains and exposing them to reinvestment risk, so investors require compensation for that option.

  1. AIt will usually offer a higher yield, because the issuer can redeem early when rates fall, disadvantaging the holderCorrect
  2. BIt will usually offer a lower yield, because the holder can require early redemption
  3. CIt has the same yield, since the option is exercised only at maturity
  4. DIt becomes convertible into shares if the call is exercised
  5. Its price rises without limit as market yields fall, unlike non-callable bonds

Explanation

The issuer will call when rates fall and refinance cheaply, capping the holder's capital gain and creating reinvestment risk. Investors therefore demand a higher yield. A holder's option would be a put, which would lower the yield. Price appreciation is capped, not unlimited.

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