e

8.5 Effect of Changes in the Level and Shape of the Yield Curve on the Value of a Callable or Putable Bond.

  • The value of a callable or putable bond is also affected by changes in the level and shape of the yield curve.

For a callable bond:

  • If the yield curve shifts down, the value of the callable bond rises less rapidly than the value of the straight bond, limiting the upside potential for the investor (level effect).
  • All else being equal, the value of the call option increases as the yield curve flattens or inverts (effect of the shape).

Notes:

  • The intuition to explain the effect of the shape of the yield curve on the value of the call option is as follows. When the yield curve is upward sloping, the one-period forward rates on the interest rate tree are high and opportunities for the issuer to call the bond are fewer. When the yield curve flattens or inverts, many nodes on the tree have lower forward rates, thus increasing the opportunities to call.

For a putable bond:

  • If the yield curve shifts up, the value of the putable bond falls slower than the value of the straight bond, limiting the downside loss for the investor (level effect).
  • All else being equal, the value of the put option decreases as the yield curve flattens or inverts (effect of the shape).

Notes:

  • The put option is considered a hedge against rising interest rates for investors.
  • When the yield curve is upward sloping, the one-period forward rates in the interest rate tree are high, which creates more opportunities for the investor to put the bond. As the yield curve flattens or inverts, the number of opportunities declines.

Lesson Wrap-Up

This lesson should leave you able to explain the effect of changes in the level and shape of the yield curve on the value of a callable or putable bond. in a fixed-income context and connect it to the decisions made by issuers, investors, or analysts.

Review Prompts

  1. Explain effect of changes in the level and shape of the yield curve on the value of a callable or putable bond. in your own words.
  2. State one exam-style risk, valuation, or market implication of the effect of changes in the level and shape of the yield curve on the value of a callable or putable bond..