A portfolio manager holds a bond with several embedded options, including a call feature. If the market interest rates surprisingly rise, how would this scenario likely impact the bond's value and the issuer's incentive to call the bond?

Question: A portfolio manager holds a bond with several embedded options, including a call feature. If the market interest rates surprisingly rise, how would this scenario likely impact the bond's value and the issuer's incentive to call the bond?

Answer options:

• The bond's value would increase, and the issuer would be more likely to call the bond.
• The bond's value would decrease, and the issuer would be more likely to call the bond.
• The bond's value would increase, and the issuer would be less likely to call the bond. ✅ The bond's value would decrease, and the issuer would be less likely to call the bond.

Correct answer: The bond's value would decrease, and the issuer would be less likely to call the bond.

Explanation: When interest rates rise, bond prices generally fall. Concurrently, if rates are higher, it becomes less attractive for an issuer to call a bond (buy it back) because they would have to reissue new debt at a higher prevailing interest rate, which would increase their borrowing cost. Therefore, the bond's value decreases, and the issuer is less likely to call.