medium · Debt Capital Markets pricing-yields-curve

Why does a callable bond exhibit 'negative convexity' as interest rates fall toward the call price?

  1. Because the issuer is contractually forced to pay a higher coupon as market rates decline, compensating holders for bearing the embedded call risk.
  2. Because the effective duration of the bond shortens sharply as the issuer's embedded call option moves further out of the money.
  3. Because steadily falling rates reduce the issuer's probability of default, which then paradoxically erodes the recovery-adjusted market value of the outstanding bond.
  4. Because the bond's price appreciation is capped near the call price, as the market anticipates the issuer will redeem the bond to refinance at lower rates.

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