If the bond's coupon rate is less than the current market yield it is highly unlikely to be called? Why??

CFA Level II Fixed Income
#1

I think this is a level 1 question, but I don’t remember the reason why. Also, duration is higher for bonds with higher coupons, anyone explain why?

Thanks

#2

lower coupon means will trade less than par e.g. 85, so no point calling it (at 100) just buy it back in the market.

second point about duration is wrong. for a zero coupon duration = maturity. as you increase the coupon, then the duration decreases…

TBH I think both these are L1 topics, are they really in L2?

#3

To a bond to be called, the current market yield must be lower than the bond’s yield.

Yield is like a price. If you can get a lower price in the market right now what will you do? Correct, you will replace the current price you paying for the lower one.

A bond trading at discount means that its coupon rate is lower than its yield, but knowing that a bond coupon rate is lower than Current Market Yield does not give us any clue if the bond will be called. The correct comparisson is between the bond yield and the market yield. So do not confuse this.

If the bond yield is higher than the market yield, the bond will be called.

“The duration is higher for bonds with higher coupon rates.”

If you see how duration is calculated you will know why in 1 minute. (2015 - 2014 Schweser book 5, pag 86)

How not to foget this? Remeber that higher coupon bonds has higher price sensitivity to changes in maket yields, and since duration measures bond’s price risk (price sensitivity to changes in the market yields) this has total sense. A higher coupon bond has higher duration, therefore a higher price sensitivity.

Regards.

#4

You’re a company that has issued bonds paying a 3% coupon, and interest rates are at 5%. Why would you pay off your low coupon bonds, just so that you could issue new bonds and pay a higher coupon?

You’re incorrect: bonds with a higher coupon have a _ lower _ Macaulay duration, and, therefore, a _ lower _ modified duration.

I wrote an article that may be of some help here: http://financialexamhelp123.com/macaulay-duration-modified-duration-and-effective-duration/

#5

With all due respect, this is completely wrong.

The higher the coupon, the _ lower _ the (Macaulay or modified) duration, and the _ lower _ the price sensitivity to changes in yields.

#6

Bonds are typically called in at a market YTM for a simillar callable bond lower than the current issue. The lower the coupon rate, the higher the duration, and the more likely a bond to be called (all else the same). But at the same time, a bond paying coupons at a lower rate than the current market yield is at a discount, and would never be called in a non-falling interest rate enviroment.

So at one point, the lower coupon rates could demand a more expensive call option cost due to the increased duration, but on the other hand, they are may be unlikely to be called depending on the volatility of the interest rate enviroment.

To keep it short, since the bond is trading at a discount (the assumption here is that the bond was issued at or near par), then the bond would not be called.

#7

Yep, it’s quite easy to get the intuition down for these two:

  • duration is a measure of how fast you will ‘get your money back’. Bigger coupons means you get a bigger proportion of your total cash in the earlier in flows

  • option will be called if the loan can be refinanced at a lower interest rate. If the coupon is 6% and current interest rates are 5%, they’ll call the 6% loan and issue a 5% one instead (so if rates go above the coupon rate, it won’t be called)

#8

Thanks, this makes sense. Longer maturity, higher duration, lower coupon lower duration… add a call, shorter duration, add a put shorter duration.

#9

Um . . . no.

Lower coupon, _ longer _ duration.

#10

yeah longer, typo

#11

wink