Bonds & interest rate risk

[vitamin]

I don't think I am fully understanding this, while I don't want to just memorize it, could someone please explain? Thanks!!

Callable bonds and prepayable securities will have less interest rate risk at lower yields and putable bonds will have less interest rate risk at higher yields, compare to option-free bonds.

 

[kgl6kgl6]

Hi! vitamin

Think about Duration (slope of tangent line) as measurement of interest rate risk.

For callable bond at low yield, slope of tangent line tends to flatten-out (when compared to option-free bond), meaning low interest rate risk. Similarly for putable bond at high yield, slop of tangent line is flatter than option-free bond.

 

[lev]

I thought that when the interest rates are low the callable bond and prepayable securities are more likely to be called and prepaid, respectively. As an investor, you are stock with these unexpected cash flows and there are low yield out there. Hence, your reinvestment risk is high. What am I missing here and what tangent line are you talking about?

 

[jamespucyk]

Yes, but that is not interest rate risk, that is call risk. Interest rate risk is a change in yields will cause a change in price.

Another way to put it is Callable bonds exhibit negative duration at lower yields, this is because they no long function effectively as option free bonds, also think about it like this, with a value of [Value Bond] - [Value Option] for a callable bond you have a greater value for the option at lower rates, so much so that it really effects the value of the bond.

Accordingly so a puttable bond really gains value when yields increase (VB + VO), so at higher prices there is less negative price flucuation of the bond as the lower value of the bond is offset by the higher value of the embedded option.

 

[CFAHouston]

"Callable bonds and prepayable securities will have less interest rate risk at lower yields and putable bonds will have less interest rate risk at higher yields, compare to option-free bonds."

The easiest way I like to think about this is that if you buy a bond where you have a low coupon offered to you, then you have low callable risk - because if interest rates drop, company won't likely call your bond back because they already are paying you low coupon.


For Putable bonds, if company offers you high coupon rate, well, then if interest rates goes high in the future, you probably won't give your bond back, becuse your already getting a high coupon rate.

 

[lev]

Thanks to all! I'll definitely review this area again. The way I grasp the concept is this. Given a callable bond and rates that go down, the interest rate risk (the risk that the price of a bond goes up and it is called) is low because the call option effectively puts a cap on how high the price can go (as Schweser puts it, loosely speaking, the price of a callable bond will never go above it's call price). The reverse is true for a putable bond. Is this a good way to think about it?