Question

a. Explain the impact on the offering yield of adding a call feature to a proposed bond issue.

b. Explain the impact on the bond’s expected life of adding a call feature to a proposed bond issue.

c. Describe one advantage and one disadvantage of including callable bonds in a portfolio.

Short answer

a. Compensate the investor to call back the bond if interest rate falls.

b. Reduces the expected life of the bond

c. Advantage - offers a higher coupon and higher promised YTM

Disadvantage – offers the risk of call leading to loss

Step-by-step solution

Explanation on the impact of adding a call feature to a bond issue

On adding a call feature to a proposed bond issue would compensate the investor to call back the bond if interest rate falls sufficiently. Investors offer this option to the issuer for a price which is the higher promised yield at which they are willing to buy the bond.

Explanation on the bond’s expected life of adding a call feature

The adding of a call feature reduces the expected life of the bond. If interest rates fall substantially the likelihood of a call increases. On the other hand, the bond must be paid off at the maturity date, not later, if rates rise. This implies that the expected bond life is less than the stated maturity.

Explanation of one advantage and one disadvantage of a callable bond

Advantage - It offers a higher coupon and higher promised YTM when the bond is issued.

Disadvantage – It offers the risk of call which gives the investor the call price that he can reinvest at a lower than the yield to maturity.