Answer the below questions

Question

(a) What is the advantage of a call provision for an issuer?
(b) What are the disadvantages of a call provision for the bondholder?

What will be an ideal response?

Answer 1

(a)
Inclusion of a call feature benefits bond issuers by allowing them to replace an old bond issue with a lower-interest cost issue if interest rates in the market decline. A call provision effectively allows the issuer to alter the maturity of a bond. The right to call an obligation is included in most loans and thus in all securities created from such loans. In essence, the borrower has the right to pay off a loan at any time, in whole or in part, prior to the stated maturity date.

(b)

From the bondholder's perspective, there are three disadvantages to call provisions. First, the cash flow pattern of a callable bond is not known with certainty and so the investment value is hard to estimate. Second, because the issuer will call the bonds when interest rates have dropped, the investor is exposed to reinvestment risk. Reinvestment risk is the risk that the bondholder will have to reinvest the proceeds at relatively lower interest rates after the bond is called. Third, the capital appreciation potential of a bond will be reduced because the price of a callable bond may not increase much above the price at which the issuer will call the bond.