CFA Level 1 - Fixed Income Investments
Explain how bond coupon rates and market rates affect bond price
The relationship between the price of a callable bond, an option free bond, and the price of the embedded call option
The price of a callable bond will always be truncated when compared to an option- free bond. This is because a bond with a call option will have a set price at which the bond can be called. An option-free bond does not, and it could trade into higher prices than the stated call price of the embedded option bond.
Example:
You have two bonds that are alike except one of them can be called this year at a price of $102. If market rates decline, the price of both bonds will increase. The option free bond could trade up to $105, however. This is because of the possibility that the callable bond will be called by the issuer and, therefore, it will tend to hold the dollar price at the call price of $102. Why would you buy this bond at $105 when you will only receive $102 if the issuer calls the bond?
The price of the embedded call option will rise when interest rates decrease. This is because as rates decrease, the possibility that the bonds will be called increases, which adds value to the call option. As the price of the call option increases, the dollar price of the callable bond will decrease or be maintained at the call price.When market rates increase, both issues will tend to decline in value lock step. This is because there will be less of a chance that the bonds will be called; this will make the callable bond act like an option free bond. The price of the option will also decrease, which will also make it trade and be valued more like an option free bond.
Interest Rate Risk of a Floating-Rate Security
Although a floating rate helps to reduce interest-rate risk because of the reset of the rate at periodic times; the price can fluctuate for three reasons:
1.The longer the reset period, the greater the potential price movements will be. The basis is the same as it is for a fixed-rate bond. The longer the time to maturity or the longer to reset, the more market events can affect the price of the bond.
2.The required margin could change. For example, let's say that when an investor originally purchases a bond, the spread over the index that was required by the market was 15 basis points. Because of market events, however, the spread that is required by the market is now 45 basis points. This would cause the floater's price to decline. The opposite would occur if the spread came in to 5 basis points.
3.Floaters usually come with caps. Once this cap value is breached, the reset interest rate can no longer go above a certain level. This will cause it to act much like a fixed-rate security in a rising interest rate environment, meaning the value of the floater will decrease because it can't keep up with current market rates.
- If a bond's coupon rate is above the yield required by the market, the bond will trade above its par value or at a premium.This will occur because investors will be willing to pay up on the bonds price to achieve the additional yield. As investors continue to buy the bond, the yield will decrease until it reaches market equilibrium. Remember that as yield decrease, bond prices rise.
- If a bond's coupon rate is below the yield required by the market, the bond will trade below its par value or at a discount. This happens because investors will not buy this bond at par when other issues are offering higher coupon rates, so yields will have to increase, which means the bond price will drop in order to induce investors to purchase these bonds. Remember that as yields increase, bond prices fall.
The relationship between the price of a callable bond, an option free bond, and the price of the embedded call option
The price of a callable bond will always be truncated when compared to an option- free bond. This is because a bond with a call option will have a set price at which the bond can be called. An option-free bond does not, and it could trade into higher prices than the stated call price of the embedded option bond.
Example:
You have two bonds that are alike except one of them can be called this year at a price of $102. If market rates decline, the price of both bonds will increase. The option free bond could trade up to $105, however. This is because of the possibility that the callable bond will be called by the issuer and, therefore, it will tend to hold the dollar price at the call price of $102. Why would you buy this bond at $105 when you will only receive $102 if the issuer calls the bond?
The price of the embedded call option will rise when interest rates decrease. This is because as rates decrease, the possibility that the bonds will be called increases, which adds value to the call option. As the price of the call option increases, the dollar price of the callable bond will decrease or be maintained at the call price.When market rates increase, both issues will tend to decline in value lock step. This is because there will be less of a chance that the bonds will be called; this will make the callable bond act like an option free bond. The price of the option will also decrease, which will also make it trade and be valued more like an option free bond.
Interest Rate Risk of a Floating-Rate Security
Although a floating rate helps to reduce interest-rate risk because of the reset of the rate at periodic times; the price can fluctuate for three reasons:
1.The longer the reset period, the greater the potential price movements will be. The basis is the same as it is for a fixed-rate bond. The longer the time to maturity or the longer to reset, the more market events can affect the price of the bond.
2.The required margin could change. For example, let's say that when an investor originally purchases a bond, the spread over the index that was required by the market was 15 basis points. Because of market events, however, the spread that is required by the market is now 45 basis points. This would cause the floater's price to decline. The opposite would occur if the spread came in to 5 basis points.
3.Floaters usually come with caps. Once this cap value is breached, the reset interest rate can no longer go above a certain level. This will cause it to act much like a fixed-rate security in a rising interest rate environment, meaning the value of the floater will decrease because it can't keep up with current market rates.
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