8.15.2005

Q&A: Explain why most of the callable investment-grade corporate bonds...

... are issued during late 1980s and early 1990s.

Calls were mispriced in the early 1980s but are priced fairly now given the development of options pricing models and other financial innovations in the market that allow the investors to price calls separately from the underlying bond. (The call feature in a perfect market is a matter of indifference: the call gives the issuer the right to call. But the investor will discount the value of the bond by precisely the price of the call option. Callable bonds have a role only if there is a systematic mispricing of the call. Mispricing can be due to two factors. First, the investors tend to undervalue the call relative to the issuers. This will motivate the issuer to issue callable bonds. Second, the issuer is more optimistic than the investors about the future credit reputation. This encourages them to issue callable bonds. If the issuers are right, they can call the bonds when their rating improves. This will enable them to issue cheaper debt later.)

Category: C++ Quant > Debt

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