1 Briefly Explain Why Many Corporations
1. Briefly explain why many corporations prefer to issue callable long-term corporate bonds rather than non-callable long-term bonds.
There are three main reasons why a corporation may be interested in calling a bond.
* Interest rates have fallen, so they can refinance at a lower rate.
* Credit quality has improved, so they can refinance at a lower rate.
* Assets have been sold, so money is available to pay off debt.
If a bond issuer pays investors the going rate of 7% annually in interest, and then the going rate declines to 6%, the company may redeem its callable bonds, replacing them with new bonds paying 6% annually.
This is especially crucial for bonds with maturity dates 20 years or more into the future. Without callability, a company might issue bonds with a high interest rate and not be able to change the rate for 20 years. The company could find itself locked into a high rate for many years at a time when new bonds are being issued with much lower interest rates. The company would be at a competitive disadvantage if it continued to finance its debts at the old, higher rate.
Companies are often willing to pay a premium to redeem the bonds before maturity, to avoid the above scenario. Callability enables the company to respond to changing interest rates, refinance high-interest debts, and avoid paying more than the going rates for its long-term debts. 2. Briefly explain the idea behind an Immunized Bond Portfolio.
With an Immunized Portfolio, the duration and convexity of the assets is set to match the duration and convexity of the liabilities. The PV of the assets is set greater than the PV of the liabilities. For small changes in yield, the asset value should increase or decrease proportionally to the changes in the value of the liabilities. This method insures that the return on the assets and the return on the liabilities remain the same. Another way of looking at it is that immunization sets the price risk exactly equal to the reinvestment risk.
There are three main reasons why a corporation may be interested in calling a bond.
* Interest rates have fallen, so they can refinance at a lower rate.
* Credit quality has improved, so they can refinance at a lower rate.
* Assets have been sold, so money is available to pay off debt.
If a bond issuer pays investors the going rate of 7% annually in interest, and then the going rate declines to 6%, the company may redeem its callable bonds, replacing them with new bonds paying 6% annually.
This is especially crucial for bonds with maturity dates 20 years or more into the future. Without callability, a company might issue bonds with a high interest rate and not be able to change the rate for 20 years. The company could find itself locked into a high rate for many years at a time when new bonds are being issued with much lower interest rates. The company would be at a competitive disadvantage if it continued to finance its debts at the old, higher rate.
Companies are often willing to pay a premium to redeem the bonds before maturity, to avoid the above scenario. Callability enables the company to respond to changing interest rates, refinance high-interest debts, and avoid paying more than the going rates for its long-term debts. 2. Briefly explain the idea behind an Immunized Bond Portfolio.
With an Immunized Portfolio, the duration and convexity of the assets is set to match the duration and convexity of the liabilities. The PV of the assets is set greater than the PV of the liabilities. For small changes in yield, the asset value should increase or decrease proportionally to the changes in the value of the liabilities. This method insures that the return on the assets and the return on the liabilities remain the same. Another way of looking at it is that immunization sets the price risk exactly equal to the reinvestment risk.