Callable Bond Prices, Exercise Decisions, and Call Penalties

Summary

The document considers a Bermudan callable bond whose observed price appears to approach its redemption value before a call date and then rise when the issuer does not call. It explains that an arbitrage-free model may predict a call when the issuer has strong credit, making the price behavior around an unexercised call appear abrupt. The pattern follows from the model’s expectation of redemption and the market’s repricing after the expected call is skipped.

The explanation cautions that theoretical models may omit real costs of refinancing, including issuance, regulatory, and administrative expenses. Those costs can affect the issuer’s decision even when a model indicates that calling is attractive. Some models account for this gap by allowing estimated call probabilities or call penalties. The discussion is qualitative: it gives no bond-specific valuation, calibration procedure, or evidence establishing whether the price history in the question is correct. Comparable bonds and an assumed yield alone are not assessed.

Key ideas

• A callable bond’s price can reflect the model’s expectation that the issuer will exercise at an upcoming call date.
• If the issuer skips an expected call, the bond may reprice upward relative to that expectation.
• Refinancing, regulatory, and administrative costs can influence the issuer’s exercise decision.
• Some models incorporate estimated call probabilities or penalties.
• The explanation does not validate the specific bond’s price history or provide a valuation method.

Tags

# Callable bond pricing


# Callable bond pricing












I have a HKD callable bond maturing in 2022. the call schedule is bermudan and the next call date is 10/17/16 and redemption price is 100 (the call date is 10/17 every year till maturity). Initially it was priced to next call date using a comparable that was maturing around previous call date 10/17/15. The yield was around 1.1% based on comparables. If I look at the history, a year prior to now it started at a price of 104 and slowly converged to call price and now it again jumps back to 104.

My question is - is this correct? i.e. is pricing to next call and jumps around call date justified? I don't have a comparable bond maturing in 2022, but do have a few maturing around the next call date.

## Answer by Brian B (score 2)

https://quant.stackexchange.com/a/21314

It's often true that a bond handled in some arbitrage-free model has pricing behavior like that. Usually, the situation is that the issuer has pretty good credit, so from a theoretical point of view they should (almost certainly) be calling the bond at the next call date. The arbitrage price captures that and so it bounces up once the company declines to call the bond, against theoretical expectations.

Of course, calling a bond away in practice carries many costs not captured in most models, such as investment bank fees for issuing a replacement bond, regulatory fees and employee time, etc. etc. This is what is driving the company's decision.

Sometime you will see arbitrage models where traders can enter their guesses at call probabilities, or sometimes estimated call penalties, to compensate for the phenomenon.

Shown in full with attribution under the source's licence. Licence: CC BY-SA 4.0 (Stack Exchange)

This summary was written by Stratmill's research agent from the original; it is not a copy of the source.