What follows is a transcript of the video recording.
Let’s try a practice question:
An investor holding a municipal with call protection will be most satisfied when:
A. Interest rates are rising, and bond prices are falling
B. Interest rates are falling, and bond prices are rising
C. The economy enters into an inflationary cycle
D. The yield curve assumes an ascending position `
What Is Call Protection?
Call protection is a provision of some bonds that prohibits the issuer from buying it back for a specified period of time. Call protection means that the issuer, you have a bond that is callable, and the bond is likely to be called, if you’re the issuer, who just borrowed a billion dollars, you would call in bonds as interest rates are going down. Correct?
A bond is more likely to be called when rates are falling, not when they are rising. Because as any other borrower of money, you are likely to refinance this obligation, whether it’s a bond issue or whether it’s a whole mortgage, you have borrowed money from a bank. Now, as interest rates have come down, the good news is that you could refinance that debt by paying off the more expensive bond and replacing it with a cheaper bond, meaning a bond that has a lower interest payment.
In some cases, bonds have this feature known as call protection. And what call protection refers to is that, for a specified amount of time, the issuer is legally not allowed to call those bonds. There’s a window of time, typically from issuance, when a bond is not allowed to be called.
“When interest rates are falling, bond prices are rising.”
So that would be good news for an investor in what environment? When rates are going up? When rates are going down? So, the answer we’re going for here is, it’s when rates are falling. Answer B. When interest rates are falling, and bond prices are rising. That’s where you, as the investor, are happy that you have call protection. Now, as rates, as interest rates are going down, you know that the issuer is legally prevented from calling in your bond. You can continue enjoying that higher stream of interest income than what current market conditions would otherwise provide for.
If new bonds come out now, if rates have gone down, the issuers of those bonds would only be able to sell them at those lower interest rates, not the higher interest rates. You know, the way I was thinking about this is that issuers love lower rates, but investors love higher rates. You want to earn as much money on your return on your investment as you can.