medium · Debt Capital Markets pricing-yields-curve
Why does a callable bond exhibit 'negative convexity' as interest rates fall toward the call price?
- Because the issuer is contractually forced to pay a higher coupon as market rates decline, compensating holders for bearing the embedded call risk.
- Because the effective duration of the bond shortens sharply as the issuer's embedded call option moves further out of the money.
- Because steadily falling rates reduce the issuer's probability of default, which then paradoxically erodes the recovery-adjusted market value of the outstanding bond.
- 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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