Most institutional investors purchase long-term bonds, as assets for their investment portfolios, to offset long-term liabilities they have on their balance sheets. Which statement below helps explain why do they not like call provisions in bonds? (Points: 4)
Adding a call provision with a premium compensates them for their troubles.
Having a bond called may mean the fund must reinvest in other bonds, which pay lower yields to maturity.
Bonds that are called can always be re-invested at higher rates.
Bonds that are called mean the company became riskier.
The correct statement that helps explain why institutional investors do not like call provisions in bonds is: "Having a bond called may mean the fund must reinvest in other bonds, which pay lower yields to maturity."
In order to understand these options and why institutional investors may not prefer call provisions, let's break down each statement:
1. Adding a call provision with a premium compensates them for their troubles:
A call provision is a feature in a bond that allows the issuer to buy back the bond before its maturity date. This premium compensates the bondholders for the inconvenience caused by the call provision. While this may be true, it doesn't directly explain why institutional investors may not like call provisions.
2. Having a bond called may mean the fund must reinvest in other bonds, which pay lower yields to maturity:
When a bond is called, the issuer buys it back from the bondholder and may issue a new bond or borrow at a lower interest rate. This means the investor must reinvest the proceeds in other bonds, which may have lower yields to maturity. Institutional investors, who have long-term liabilities, generally seek stable and predictable income streams. So, if they need to reinvest at lower yields, it may disrupt their planned income and affect their investment strategy.
3. Bonds that are called can always be reinvested at higher rates:
This statement is not necessarily true. When a bond is called, the investor may not always find similarly attractive investment opportunities to reinvest the proceeds. The interest rate environment and market conditions play a significant role in determining the availability of higher rates. Institutional investors prefer stability and may not like the uncertainty associated with reinvesting at potentially higher rates.
4. Bonds that are called mean the company became riskier:
While it is possible that a company may call its bonds due to deteriorating financial conditions, it is not always the case. Companies may also call bonds to take advantage of favorable interest rate environments, to refinance at lower rates, or because they no longer need the capital. Therefore, the assumption that a called bond means the company became riskier is not always accurate.
In conclusion, the statement "Having a bond called may mean the fund must reinvest in other bonds, which pay lower yields to maturity" best explains why institutional investors do not like call provisions in bonds.