Sunday, September 6, 2009

Effect of coupon rates on call risk

We should note that the coupon rate on a bond is closely related to the investor‘s call risk. We recall that a bond‘s coupon rate is the rate of return against the security‘s par value promised by the borrower. High coupon rates mean that a bond issuer is forced to pay high interest costs as long as the bond is outstanding. Therefore, there is a strong incentive to call in such bonds and replace them with lower-coupon securities.
Another problem is that bonds bearing high coupons have less opportunity for capital gains than bonds carrying lower coupon rates. This is true because the market value of a high-coupon security is usually close to its call-price ceiling. In contrast, bonds with more-modest coupon rates sell at lower prices and carry considerably more potential for capital gains before hitting the call price. This means there is more risk of call and less potential capital gain to the investor who chooses high-coupon securities. As a result, the issuer of such securities must pay a higher yield to induce investors to buy them and accept greater call risk.

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