The Analysis of Bonds with Embedded Options

The yield calculation for conventional bonds is relatively straightforward. This is because their redemption dates are fixed, so their total cash flows—the data required to calculate yield to maturity— is known with certainty. Less straightforward to analyze are bonds with embedded options—calls, puts, or sinking funds—so called because the option element cannot be separated from the bond itself. The difficulty in analyzing these bonds lies in the fact that some aspects of their cash flows, such as the timing or value of their future payments, are uncertain. 

Because a callable bond has more than one possible redemption date, its future cash flows are not clearly defined. To calculate the yield to maturity for such a bond, it is necessary to assume a particular redemption date. The market convention is to use the earliest possible one if the bond is priced above par and the latest possible one if it is priced below par. Yield calculated in this way is sometimes referred to as j ie/d to worst (the Bloomberg term). 

If a bond s actual redemption date differs from the assumed one, its return computed this way is meaningless. The market, therefore, prefers to use other methods to calculate the return of callable bonds. The most common method is option-adjusted spread, or OAS, analysis. Although the discussion in this chapter centers on callable bonds, the principles enunciated apply to all bonds with embedded options. 

Consider a callable U.S.-dollar corporate bond issued on December 1, 1999, by the hypothetical ABC Corp. with a fixed semiannual coupon of 

6 percent and a maturity date of December 1, 2019. FIGURE 11.1 shows the bond s call schedule, which follows a form common in the debt market. According to this schedule, the bond is first callable after five years, at a price of 103 after that, it is callable every year at a price that falls progressively, reaching par on December 1, 2014, and staying there until maturity. 

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As introduced in Chapter 8, the most suitable measure of return for bonds with embedded options is known as option-adjusted spread or OAS. In this chapter, we show the analysis of bonds with embedded options, with particular focus on pricing methodology. 

Chapter 11—The Analysis of Bonds with Embedded Options... 

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