Can someone please explain why a callable bond is most likely to be called when interest rate volatility is high, such that the callable bond decreases in value with volatility?
Put yourself in the shoes of the CFO. If interest rates drop to a certain level below the current rate on your bonds, you will refinance your callable bonds to reduce your interest expense. More volatility means a better chance that the interest rates will drop below your current rate which will lead to the current bond being called by the company as it refinances. This means the bond has a higher probability of being called in a low interest rate environment so it is valued lower than a bond that is not callable.
Having done that, give yourself a huge bonus, cash in all of your stock options, resign and retire, and forget all of this silly CFA nonsense.
Thank you for your answer!
Though, to me, more volatility could also mean rates might increase…
And what happens to the value of a bond when interest rates increase?