Are embedded calls valuable? Evidence from agency bonds

Abstract

This paper examines the call option values embedded in callable agency bonds. For FHLB, FNMA, and SLMA bonds, call value estimates range from 1.23% of par to 1.47% on average, which are between those for the treasury and corporate debt securities. FHLMC bonds, on the other hand, have an average call value estimate of 2.85%. Call values are significantly larger for bonds with a longer remaining maturity and greater default risk. Most interestingly, call values in the call protection period are significantly larger than those in the callable period except for the SLMA bonds, whereas previous studies on corporate debt find no significant difference in call values between these two periods.In general, call value exhibits a downward trend over time as the callable bond approaches maturity. Also, call value is inversely related to the level of interest rates. Interest rate drops are usually accompanied by an increase in call values. An analysis of the determinants of call values suggests the following conclusions. First, call values are negatively related to short-term interest rates and the slope of the yield curve, and positively related to coupon rate and remaining maturity. Second, bonds with a greater amount of call protection have smaller call values, which is in contrast with the finding in a previous study on corporate debt that call protection period has little effect on call value.