Callable bonds and puttable bonds, Financial Management

Assignment Help:

Convertible bonds can be classified into different types such as callable bonds and puttable bonds. These bonds are discussed as follows:

Basics of Callable Bonds

A callable bond is a convertible bond with a favorable feature of call option available to the issuer. When the firm feels that its stock is undervalued in such a way that selling stock directly would dilute the equity of current stockholders and if the firm does not prefer the route of debentures/debt, then it issues a convertible bond duly setting the conversion ratio on the basis of a stock price acceptable to the firm. Once the market price reaches the conversion point, the firm will want to see the conversion happen in view of the risk that the price may drop in the future.

The holder of a callable bond thus gives the issuer the right to call the issue prior to the expiration date. In fact the bondholder is put to two disadvantages. First, the bondholders are exposed to the reinvestment risk, since an issuer will call the bond when the yield on bonds in the market is lower than the issue's coupon rate. Let us try to understand this concept with the help of an example. Suppose a firm has issued a callable bond with a coupon rate of 13%. Subsequently the market rates come down to 7%. When funds are available at 7% in the market, why should the firm pay interest at 13% to the bondholders? Since it has the option to call it utilizes the opportunity, pays cash to the bondholder by going for the 7% issue.

The second disadvantage is that, the price appreciation potential for the callable bond in a declining interest rate regime is limited. This happens because the investors can reasonably expect that the firm would prefer off-loading the bonds by redeeming at the call price since the market rates of interest have fallen. This phenomenon of a callable bond is called price compression.

In view of the two disadvantages associated with callable bonds and in order to make them attractive, the issuer often provides a call protection for an initial period, akin to the lock-in-period during which the bond may not be called. Despite this why would any investor prefer this at all with inherent reinvestment risk and price compression unless otherwise sufficient potential compensation in the form of a higher potential yield is explicitly provided?

The yield to call assumes that (i) the investor will hold the bond to the assumed call date, and (ii) the issuer will call the bond on the date. But these assumptions are unrealistic in the sense that they do not take into account the rate at which the investor can reinvest the proceeds after the issue is called. For example, for a five year bond, the investor intends to hold the bond for five years, but when the bond is called at the end of the third year, the total return for five years will depend upon the interest at which the proceeds are reinvested from the call date to the end of the fifth year. Thus it is not possible to calculate the yield to maturity for such callable bonds.

 


Related Discussions:- Callable bonds and puttable bonds

Show example on cross currency swap, 1. Of course a swaption will be needed...

1. Of course a swaption will be needed. The major reasons being that Bond A is callable after 3 years and matures in 4 years whereas Bond B matures in 5 years. It is understandable

Explain the concepts of planning the work, Explain the concepts of Planning...

Explain the concepts of Planning the work Determine scope and objective of the audit (to verify assets, to check adequacy of internal controls etc...). Ensuring appropr

Accrual bond, It is a bond that does not give periodic interest payments. I...

It is a bond that does not give periodic interest payments. In spite of that, interest is added to the principal balance of the bond and is either paid at maturity or, at some poin

Type of assets, type of assets for ppt from t.y.bom com student in commerce...

type of assets for ppt from t.y.bom com student in commerce department in financial management

Monthly cash flow, I need to prepare a monthly cash flow for a company with...

I need to prepare a monthly cash flow for a company with the given information, and need to comment on the current performance and the future sales increment. Then we need to find

Determine about the call and put option, Determine about the call and put o...

Determine about the call and put option A call/ put option provision allow both issuing company and investor to redeem the bonds at a specified amount before maturity date. Lon

Explain the compound interest, What is compound interest? Compare compound ...

What is compound interest? Compare compound interest to discounting. Compound interest takes place while interest is earned on interest and on the original principal of an invest

ASSIGNMENT, Assume that we have the following data: C=100+0.50Y Ip=100-20r...

Assume that we have the following data: C=100+0.50Y Ip=100-20r Mt=0.10Y Ms=100-10r M=80 a. Build the IS-LM function. b. If we assume an increase in Investments by 100 units, p

Explain about the financial risk, Explain about the Financial risk fina...

Explain about the Financial risk financial risk are presumed to be constant, changing cost of each type of capital, j, over time must be affected only by changes in the supply

Evaluate cost of preference share capital, Q. Evaluate Cost of Preference S...

Q. Evaluate Cost of Preference Share Capital? Cost of Preference Share Capital: - A fixed rate of dividend is to be paid on preference shares. However unlike debt the dividend

Write Your Message!

Captcha
Free Assignment Quote

Assured A++ Grade

Get guaranteed satisfaction & time on delivery in every assignment order you paid with us! We ensure premium quality solution document along with free turntin report!

All rights reserved! Copyrights ©2019-2020 ExpertsMind IT Educational Pvt Ltd