Chartered Financial Analyst (CFA) Practice Exam Level 2

How does a declining interest rate environment typically affect callable bonds?

1. Issuers are less likely to call the bonds.

2. Issuers typically want to call back the bonds.

3. Callable bonds become more valuable for investors.

4. Investors will exercise the put options more frequently.

The correct answer is: Issuers typically want to call back the bonds.

In a declining interest rate environment, callable bonds typically see issuers taking more interest in calling back the bonds. When interest rates fall, issuers can refinance their debt at lower rates, which leads to significant cost savings. This creates an incentive for them to call the existing bonds, as they may be paying higher interest than what they would incur if they issued new debt at the current lower rates. This process is beneficial for the issuer because they reduce their interest burden. As a result, callable bonds are often called when rates drop since issuers can secure more favorable financing, making this the most accurate choice in this context. Other factors to consider include the potential impact on investors. While callable bonds may become less valuable as the likelihood of being called increases, callable bondholders’ potential capital gains in a falling interest rate environment diminish since their bonds will be redeemed before they can benefit fully from the interest rate decline. Therefore, the reasoning ultimately supports that issuers are motivated to call the bonds in a declining interest rate scenario.