Innovation is prevalent in the Fixed Income Markets usually undertaken to reduce
ID: 2618078 • Letter: I
Question
Innovation is prevalent in the Fixed Income Markets usually undertaken to reduce the cost of capital and/or reduce tax exposure for an issuer. A very popular innovation is embedding an option within a bond. Bonds are offered in the market with embedded calls and puts. Value of the bond can then be considered the value of a plain vanilla bond and the value of the option.
This would make the value of a bond with an embedded call to be more expensive than a plain vanilla bond and the value of a bond with an embedded put to be more expensive than a plain vanilla bond.
Is this correct? Please explain. Also, please identify how these two innovations reduce cost of capital and/or tax exposure for the issuer.
Explanation / Answer
No it is incorrect
In case of embedded call, the yield of callable bond is higher than straight bond or value of the bond is less than value of straight bond
In case of embedded put, the yield of puttable bond is lower than straight bond or value of the bond is more than value of straight bond
As cost of capital is equal to yield, cost of capital is lesser in case of puttable bond for the issuer.