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Sunday, April 03, 2005

Premium Callable Bonds and Interest Rate Risk

Here's a good NYT article on premium callable bonds, titled "It's Name Is a Mouthful, SO Just Call It a Rate Shield". It begins:

After months of false alerts, longer-term interest rates may finally be moving up in earnest. If the trend continues, fixed-income investors who have not prepared will be taught an ugly lesson: as yields rise, prices fall and the value of a bond portfolio declines.

But there are ways to minimize the pain. The most common moves are to sell longer-term bonds and to hold cash or shorter-term securities, which won't be hurt as badly as their cousins with longer maturities. Some portfolio managers also use futures contracts to hedge against rate increases.

But professionals are also using a less known way to cushion a bond portfolio: by buying premium callable bonds.
The article is a good one to use when discussing duration (a measure of how far off in the future the cash flows from a financial security are on average). Duration is a measure of a bond's price sensitivity to interest rates, because the present values of distant cash flows are affected by changes in interest rates more than are the present values of cash flows that are closer in time to the present. Premium callable bonds have lower duration for a number of reasons:

  1. The bond are selling at a premium becuse they pay a coupon rate that is higher than the rate on bond that sells at par. So, since a bond's cash flows consist of coupon payments and a lump sum at the end, a premium bond has relatively more of its cash flow in the form of coupon payments (which occur before maturity).
  2. Since the bond is at a premium, it is more likely to be called. So, the "term" if the bond is likeley to be much shorter, resulting in a shorter duration.
The article then concludes with a few scenarious where a premium callable bond has some increased risks.

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