The explanation I’d give myself here is the following :
Initial assumption : callable bonds pay HIGHER coupons than non-callable because we, investors, run the risk that the issue might call back by the issuer if the int. rates fall.
INVESTOR CASE :
let’s assume we invested in a non callable- bond because we expected interest rates to fall (given we want to have a long-term investment and avoid reinvestment risk, we deliberately gave up some extra-coupons we could have received if we had invested in callable bonds..). Later we realise that our choice hasn’t turned to be optimal given the current market conditions do not change OK? What we do?
We can still improve our current income by adding this “extra income” by going long on a receiver swaption (we synthetically added the callable feature);
ISSUER CASE
We issued a callable bond because we were afraid int. rates were about to fall. In fact int. rates do not fall and we pay higher coupons.
What we do?
We can still improve by loweing our current payments to investor by going short (sell) on a receiver swaption (we synthetically removed the callable feature); The premium (cash) we received partially offset the coupon payment we are exposed to.
Hope it makes sense
