The structure of the transaction is as follows: The first tranche consists of EGP 203m, 13-month non-callable bond
with a variable yield of 40 basis points (bps) over the net after tax return on 182-day Egyptian treasury bills (T-Bills).
Thus, a mortgage effectively is composed of a long-term non-callable bond
plus an embedded call option that gives the mortgager the right (but not the obligation) to buy back (call) the bond at par.
A complete discussion is beyond the scope of this article, but I would like to make an important point about bonds with embedded options or call features, and non-callable bonds
. As we are fully aware, bond prices move in the opposite direction of interest rates.
In this study, the authors test whether callable bonds have lower agency costs of debt than non-callable bonds. The paper also examines whether an explicit contractual restriction on risk incentive-triggered transactions reduces the agency costs of debt.
That is, the authors empirically test whether callable bonds have lower agency costs of debt than non-callable bonds. Also examined is whether an explicit restriction on risk incentive-based transactions effectively reduces the agency costs of debt.
[X.sub.4i] = 1 for callable bonds and 0 for non-callable bonds (contracting variable).
Regardless of a bond's maturity, McGregor suggests buying top-rated (AAA or AA), non-callable bonds
. That is, avoid bonds that permit the issuer to buy them back if interest rates fall, in which case you'd have to reinvest at lower yields.
Of course, there is a cost: The interest rates on 10-year callable bonds for Freddie Mac are about 100 basis points above the cost of comparable non-callable bonds
. The reduction in F&F profits, however, would be less than the reduction created by an explicit portfolio size limit.
They use a theoretical, tax-timed, bond-pricing model and show that a comparison of callable bonds with non-callable bonds
that mature on the first call date provides a valuation for an implied put option.