Question
Which of the following methods of retiring bonds before
maturity is generally considered the most detrimental to the bondholders?Solution
A call provision refers to a clause – essentially, an embedded option – in a bond purchase contract that gives the bond’s issuer the right to redeem the bond early, before its maturity date. Bonds with such provisions are referred to as callable bonds. Callable bonds usually offer higher yields than similar non-callable bonds to compensate investors for the risk of the bond being redeemed early, which will reduce the total amount of coupon payments (interest) that bondholders receive. The most common motivation for an issuer, including an early redemption option with a bond issue, is to be in a position to take advantage if prevailing interest rates decline significantly during the life of the bond which might not be very beneficial for bondholders as it poses them the reinvestment and interest rate risk
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