Options and their Benefits

CFA Level 1 - Fixed Income Investments

For options that benefit the issuer, such as calls, investors will want yield spreads that are greater than bonds and that do not have options embedded in them. Because there is a risk that the bonds will be called, investors want a higher yield to compensate for that risk, causing the spread to widen over the treasury security when compared to bonds without options. The longer the call period, the less spread widening investors will be needed because of a longer protection period against the call.

Options That Benefit the Holder
For options that benefit the holder, such as puts, investor will require a smaller yield spread than bonds that do not have embedded options in them, such as treasury bonds. There is even the possibility that the coupon rate could be lower than the treasury coupon rate, depending on how favorable the option is to the investors.

Spreads and Liquidity
When issues are less liquid, yield spreads tend to widen because there are fewer bonds to buy or it is harder to find a buyer. When issues are more liquid, such as on-the-run treasuries, yield spreads are tighter or narrower because there are plenty of buyers and sellers.

The larger the issue size, the more liquidity compared to a smaller issues in the market leads to tighter or narrower spreads and vice versa.

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