Question

Suppose microsoft issues 2 bonds with identical coupon rates and maturities date. one bond is callable, the other is not. which bond will sell at a lower price?

A. not enough information
B. the non-callable bond
C. the callable bond

Answer 1

The callable bond (option C) will sell at a lower price than the non-callable bond because it includes the risk for the bondholder of the bond being redeemed early if interest rates drop.

Step-by-step explanation:

If Microsoft issues two bonds with identical coupon rates and maturities, one bond being callable and the other non-callable, the callable bond will generally sell at a lower price. The reason for this is that the callable bond gives the issuer the option to redeem the bond before the maturity date, typically when interest rates have fallen, and they can reissue debt at a lower rate. This option adds potential risk for the bondholder, as it limits the upside potential if interest rates fall. Therefore, investors will require a higher yield to compensate for this risk, which translates to a lower price for the callable bond compared to the non-callable bond.

The non-callable bond does not carry this risk, and as such, retains its value better when interest rates fall since the issuer does not have the option to call the bond. This means that the holder of the non-callable bond continues to receive the agreed coupon rate until maturity. Thus, the non-callable bond will sell at a higher price than the callable bond, all else being equal.