Saturday, December 20, 2008

The Debts of the Spenders: Are Callable Bonds The Heralds of The Next Storm?

The new threat is the callable bond.

Callable bonds are like options for the issuer. Issuers have the right - but not the obligation - to redeem the bond before maturity at the call price.

Callable bond holders are compensated for this uncertainty by getting paid a higher coupon (interest rate).

In options terms, the bond buyers are the option sellers. They get paid a premium to assume extra risk.

Callable bond issuers benefit because they bet on interest rates to fall at some time before maturity so they can refinance their debt at a cheaper rate. Similarly the bond holder benefits when interest rates fall and the bond's value rises. When the debt is redeemed it is done so at a premium to benefit the bond buyer. So, the bond buyer benefits 2x:

a) higher coupon and
b) higher premium.

The difference b/t options and bonds is that the bond buyers EXPECT the bond issuers to redeem at some point. There is an implied assumption that the bond seller will try to refinance the debt for the reason I just explained in the prior paragraph. It is expected and priced into the market.

If bond issuers do NOT redeem WHEN interest rates have fallen to new lows, they risk upsetting the bond markets and panicking bond holders (aka institutions).


The automatic assumption among the bond holders is that the bond issuer is at such risk that NO ONE wants to refinance their debt because of...

Potential Default.

So which sectors issue the most callable bonds?

Munis, commercial real estate, and European banks.


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