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).
The sample has 150 callable bonds and 54 non-callable bonds. Other bond features such as amount raised, maturity, coupon rate, and bond rating were collected as well.
Most noteworthy, the binary call feature variable (i.e., 1 for callable bonds and 0 for non-callable bonds) is negatively related to the bond rating, and its coefficient is statistically significant with a p-value close to zero.
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.