Thursday, August 27, 2009

The Call Premium and Interest-rate Expectations

For all of the foregoing reasons, securities that carry a call privilege generally sell at lower price and higher interest rates than non-callable securities. Moreover, there is an inverse relationship between the length of the call deferment period and the required rate of interest on callable securities. The longer the period of deferment and, therefore, the longer the investor is protected against early redemption, the lower the interest rate which the borrower must pay. Issuers of callable securities must pay a call premium in the form of a higher rate of interest for the option of early redemption and for a shorter period of deferment.
The key determinant of the size of the call premium is the interest rate expectations of investors in the marketplace. If the interest rates are expected to rise over the term of a security, the risk that the security will be called is low. Borrowers are very unlikely to call in their securities and issue new ones at higher interest rates. As a result, the yield differential between callable and non-callable securities normally will be minimal. Moreover, in this case call deferments will be of limited value to investors, and yields will be roughly equivalent for securities with varying call features call feature. The same conclusions apply even if interest rates are expected to decline moderately but not enough to entice borrowers to call in their securities and issue new ones.
It is when interest rates are expected to fall substantially that securities are most likely to be called. In this instance security issuers can save large amounts of money-more than enough to cover the call privilege. Thus, the call premium is likely to be significant as investors demand a higher yield on callable issues to compensate them for call risk. Moreover, the yield spreads between bonds with long call deferments versus those with short or no call deferments widen during such periods as investors come to value more highly the deferment feature.

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