An Analysis of Call Strategy in the Eurodollar Bond Market*

Abstract

AbstractIn a perfectly efficient market, a bond issuer should be indifferent between issuing non‐callable and callable debt. Yet, most bonds in the U.S. market are callable whereas non‐callable bonds are the norm in the Euromarkets. This paper first examines empirically the factors that determine whether callable or non‐callable Eurodollar debt is issued. It is found that bond characteristics such as the coupon and issuer characteristics like nationality are of particular importance. Next, the timing of calls for bonds outstanding during 1985 to 1988 is studied. It is found that borrowers called as early as possible, not surprising given the steep drop in interest rates during that period. Bonds were called much sooner and the premium was much larger in the Euromarket than indicated by previous studies confined to the U.S. domestic market. Investors were unable to anticipate in advance, even in a low interest rate environment, those issues eventually called and those delayed. The paper has practical implications for financial managers who must decide whether to include a call option in debt, thereby trading off a higher coupon against the possibility of saving money later.SummaryWe examined in this paper a number of reasons for the presence or (more appropriate recently) the absence of calls in Eurodollar issues. We explored the relationship between call presence and issuer characteristics such as nationality and type. We looked at the impact of prevailing interest rates and maturity on the strategic decision on whether or not to include an embedded option. Our empirical results show that most issuers follow an optimal call strategy which given the drop in recent interest rates means they call as early as possible. Yet not all bonds are called on the first callable date. Even in the case of high coupon bonds, only about 70% are called immediately with this number rising to about 90% within six months.Option pricing models generally assume that investors believe that borrowers intend calling on the first callable month. However, our research shows that in many instances, this does not match the eventual call behavior of borrowers. Investors, ex ante are unable to distinguish between those bonds that will be called immediately and those that will be delayed. Investors do not correctly price all callable Eurodollar bonds since they assume issuers will follow an optimal call strategy. The results, therefore, have important implications for bond pricing. Since callable bond prices are a function of the anticipated call policy, the pessimistic attitude of investors regarding the true maturity of their Eurobond investment means underpricing of issues often occurs. Researchers have failed to properly incorporate such 'sub‐optimal’ behavior into fixed‐income pricing models. Non‐economic refinancing motives such as those caused by divorce or employment relocation play a key role, for example, in home mortgage prices and tentative attempts have been made to incorporate sub‐optimal behavior when modelling prices in this market. The results in this paper indicate that a similar approach might prove to be also a fruitful research area in international securities markets.Finally, it is clear from this paper that more research should be conducted to develop and test theories to explain differences between domestic and Eurobond markets. Our results on call policy suggest there is a particular need for comparative behavioral studies of both investors and borrowers in these markets.