The Effect of the Yield Curve on a Bond's Call Premium

Authors

Wesley M. Jones Jr., The Citadel
George Lowry, Randolph-Macon College
Mark Bebensee, The Citadel

Abstract

Much of today's corporate debt is callable, and the value of the call provision attached to a corporate debt instrument is a function of the likelihood of the call provision's being exercised by the bond issuer. This study examines the effect of the shape of the yield curve on the value of the call premium placed on callable bonds over similar non-callable bonds. Since a bond issuer will only call a bond when interest rates are lower than they were at the time of the bond's issue; the likelihood of a call being exercised will increase as interest rates are expected to decline over time. The market conveys its expectations about the future direction of interest rates by the way it prices fixed-income securities. This expectation is reflected in the shape of the yield curve on government debt. If the yield curve is upward sloping, then the market is conveying its expectation that, over time, interest rates will rise. This would represent a set of expectations that reduces the likelihood that a call would be exercised, reduces the value of the call premium, and drives the price of the callable issue closer to the price of similar non-callable issues. Conversely, if the yield curve is downward sloping, then the market is conveying its expectation that, over time, interest rates will decline. This would represent a set of expectations that increases the likelihood that a call would be exercised, increases the value of the call premium, and drives the price of the callable issue below the price of similar non-callable issues.

Recommended Citation

Jones, Wesley M. Jr.; Lowry, George; and Bebensee, Mark (2010) "The Effect of the Yield Curve on a Bond's Call Premium," The Coastal Business Journal: Vol. 9: No. 1, Article 1.
Available at: https://digitalcommons.coastal.edu/cbj/vol9/iss1/1