A bond the issuer may redeem early at set prices on set dates; the investor is effectively short a call option and is paid a wider spread for it.
Issuers call when rates have fallen or their credit has improved, which is precisely when the holder would least like to be repaid. The bond's upside is therefore capped near the call price, producing negative-convexity as yields fall.
Price a callable at yield-to-worst, never at yield to maturity, and compare spreads on an option-adjusted-spread basis so the option is valued rather than mistaken for credit compensation. Its interest rate sensitivity must be measured with effective-duration.
Example: a 6% bond callable at 102 in two years trades at 104. Yield to maturity looks like 5.4%, but yield-to-call is 4.0%. If it is called you lose two points of price, so 4.0% is the number to use.
Original diagrams for the ideas on this page. Illustrative, not real market data.
Buying a call: payoff at expiry. A 105-strike call bought for 3 loses that whole 3 if the price finishes at or below 105, breaks even at 108, then gains a dollar for every dollar higher. The loss is capped at the premium; the upside is not capped.The bid-ask spread. Buy orders sit below, sell orders above, and the gap between the best bid (50.01) and best ask (50.04) is the spread you pay to cross. Bar length shows the size resting at each price.
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