If you buy a callable bond and interest rates decline, will the value of your bond rise by as much as it would have risen if the bond had not been callable?
To determine the impact of declining interest rates on the value of a callable bond, let's first understand what a callable bond is and how it works.
A callable bond is a type of bond that includes a provision allowing the issuer to redeem or "call" the bond before its maturity date. When interest rates decline, the issuer of a callable bond has an incentive to call and replace the existing bond with a new bond at a lower interest rate, thereby reducing its borrowing costs.
As an investor, if you own a callable bond and interest rates decline, the potential value increase of your bond will be limited due to the issuer's ability to call the bond. When interest rates decline, the value of fixed-rate bonds generally rises because their higher coupon rates become more attractive relative to prevailing market rates.
However, the presence of a call option in a callable bond places a ceiling on its potential value increase. If interest rates decline significantly, the issuer may choose to call the bond and reissue it at a lower interest rate, limiting the extent to which the bond's value would have risen.
In summary, if you buy a callable bond and interest rates decline, the value of your bond may not rise by as much as it would have risen if the bond had not been callable. The potential upside may be limited due to the issuer's option to call the bond and replace it with a bond at a lower interest rate.