Government Bond Research

Callable Securities: An Introduction

February 1998 Douglas Johnston 212-526-6566

Callable securities offer an attractive way for investors to combine their views on market direction, curve shape, the range of rates, and implied volatility. We examine the risks and rewards of owning callable securities and highlight strategies that can be employed. Buyers of callable securities, who have sold embedded interest rate options, must compare the coupon they are receiving to forward rates imputed from the issuers credit curve. Par-priced securities do not guarantee that the options are at the money. We investigate the relationship between curve-adjusted nominal spreads and market level, and highlight the correlation. Nominal spreads, adjusted for duration, tighten as the embedded options move into or out of the money. By contrasting the partial duration exposure of callable securities to comparable bullets, we determine the yield curve exposure of different lock-out/maturity structures. In addition to being short convexity, callables have a flattening bias. Premium callables are best suited for the bullish investor who believes that rates are unlikely to rally too far. Discount callables are the better choice for selling volatility in a limited bearish environment.

Publications: M. Parker, D. Marion, V. Gladwin, A. DiTizio, C. Triggiani, B. Davenport, J. Doyle

This document is for information purposes only. No part of this document may be reproduced in any manner without the written permission of Lehman Brothers Inc. Under no circumstances should it be used or considered as an offer to sell or a solicitation of any offer to buy the securities or other instruments mentioned in it. We do not represent that this information is accurate or complete and it should not be relied upon as such. Opinions expressed herein are subject to change without notice. The products mentioned in this document may not be eligible for sale in some states or countries, nor suitable for all types of investors; their value and the income they produce may fluctuate and/or be adversely affected by exchange rates, interest rates or other factors. Lehman Brothers Inc. and/or its affiliated companies may make a market or deal as principal in the securities mentioned in this document or in options or other derivative instruments based thereon. In addition, Lehman Brothers Inc., its affiliated companies, shareholders, directors, officers and/or employees, may from time to time have long or short positions in such securities or in options, futures or other derivative instruments based thereon. One or more directors, officers and/or employees of Lehman Brothers Inc. or its affiliated companies may be a director of the issuer of the securities mentioned in this document. Lehman Brothers Inc. or its predecessors and/or its affiliated companies may have managed or co-managed a public offering of or acted as initial purchaser or placement agent for a private placement of any of the securities of any issuer mentioned in this document within the last three years, or may, from time to time perform investment banking or other services for, or solicit investment banking or other business from any company mentioned in this document. 1998 Lehman Brothers Inc. All rights reserved. Member SIPC.

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INTRODUCTION
Callable securities offer opportunities for many fixed income investors. With the callables exposure to changes in the yield curve and volatility, these securities expand the investment universe and give investors an additional tool to outperform their benchmarks. However, with the anticipation of enhanced yield comes commensurate risks. This paper introduces callable securities and their salient features, discusses the risks due to changes in variables, and highlights strategies that can be employed to manage those risks.

Of course returns are not always good. In particular, the rally and flattening of the Treasury and agency curves at the end of 1997 increased the probability that some callable securities would be redeemed. Callable securities are more sensitive to changes in the shape of the yield curve than nominal securities. In addition, the late 1997 spike in implied volatility caused investors to reevaluate the risk premium required to sell volatility. Both effects have combined to widen nominal spreads on callable instruments, as reflected in the recent muted performance.

. . . and the Risks Why Callables?

Understanding callable securities can be advantageous. The Lehman Brothers Agency Index is composed of 51% callable securities with a market value in excess of $160 billion. The securities have substantial diversity in structure with call lockouts ranging from a few months to longer than 10 years. Price diversity, as highlighted in Figure 1, allows the investor to choose discounts, parpriced, or premium securities. In the U.S. Treasury market, callables account for almost $90 billion of securities, all of which trade at a premium with fairly long lockouts. Callables account for about 10% of market value in the Lehman Brothers U.S. Government Index. For indexed investors, not including callables in their asset allocation is equivalent to being short an asset class of sizable market value. In the Lehman Brothers Aggregate Index, callables account for almost 8% of the investment universe, including many corporate issues. There are risks associated with investing in callable securities. In addition to the usual vagaries of supply and demand, callables have embedded options that are sensitive to changes in the slope of the yield curve. The value of the options is a function of forward rates, which are dependent on the spot level of rates and spot yield spreads. Another risk is volatility, which has two forms. The first is realized volatility. Owners of callable instruments are expressing the implicit view that yields will remain relatively stable, enabling the investor to capture the yield spread over duration-matched noncallable securities. Large swings in rates can necessitate frequent rehedging, leading the investor to lock in lower returns. If these moves in rates are large and/or frequent enough, callable securities will underperform. Many investors use callable securities within a total return strategy rather than a buy and hold strategy; therefore, the second volatility risk is to changes in implied volatility, which is the market forecast of future
Figure 2.
bp

The Opportunities . . .
Callable securities make up an asset class that investors can use to enhance returns under appropriate conditions. For example, in 1997 it paid to sell volatility. And similar to mortgage-backed securities, callables performed well with declines in both actual and implied volatility. Figure 2 shows the monthly excess returns over duration-matched Treasuries of the agency callable sector, which for the year posted 53 bp of excess return.
Figure 1. Price Diversity within the Lehman Brothers Callable Agency Index, as of 11/30/97
Dollar Price < 98 98 to 102 > 102 % of Index Market Value 4.3 82.9 12.8

Lehman Brothers Callable Agency Index Monthly Excess Returns over Treasuries, 1997

15 10 5 0 -5 -10 Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec

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rate uncertainty. When a position is unwound, the value of the callable security will depend on the new level of implied volatility. If implied volatility were to increase, callable security prices would be depressed. Therefore, callable investors must have views on the likely range of rates over the investment period and the markets perception of future rate uncertainty at the horizon date. How much additional return is required to compensate for these risks is the central question for investors. Nominal spreads, and therefore prices, reflect the markets perception of the value of these risks. This report introduces investors to callable securities, highlighting the risks and rewards and the tools needed to determine if an investment in callable securities is right for a particular investor.

A callable security can be mimicked by a portfolio of a bullet security and an option to buy that security. Thus, a 10nc3 can be separated into a long position in a 10-year bullet and a short position in an option to buy that security starting three years from its issue date. The option is typically referred to as a 3x7 option, referring to the options initial expiration in three years with an underlying term of seven years. A similar option would be a 3x7 American style swaption, which is traded in the overthe-counter derivatives market. Returning to our example, the 10nc3 was offered at $100 for a yield of 6.856%. A 10-year bullet with the same coupon and a yield of 6.236% would be priced at $104.57. Thus, the embedded option was sold for a price of $4.57, thereby lowering the cost of the callable security. The relationship between the callable security and the bullet to maturity can be represented as follows:
Callable Security Price = Bullet to Maturity Price - Value of Embedded Options

DISSECTING THE CALLABLE

Breaking It Down
A callable security gives the issuer the right to redeem the security at predetermined prices at specified times. For example, the traditional 5-year security that is noncallable for one year (5nc1) is redeemable at par at any time starting on the anniversary of its issue date. Different structures may have a schedule of prices for which the issue can be redeemed or specific dates on which the issue may be called.1 The underlying theme, however, is the same: by purchasing a callable security, the investor gives the issuer the option to buy the security back. Therefore, investors who own callable securities have sold embedded interest rate options and need to be compensated appropriately. Compensation for selling the embedded option comes in the form of a higher static yield. For example, on 12/5/97 a generic U.S. agency 10nc3 was offered at a yield spread of 94 bp to the 10-year on-the-run Treasury, the 6.125% of 8/15/07. In contrast, a generic 10-year U.S. agency bullet was offered at a nominal yield spread of 32 bp over the 10-year. The additional 62 bp in static yield on the callable was compensation for selling the embedded call options. Determining the fair value of the embedded options and understanding the risks and rewards in selling them is essential for the callable security investor.
1In addition, many callable securities have notice periodsa set number of days notice the issuer must give the investor that the security will be called. For example, callable Treasuries are discreetly callable on coupon dates with 120 days notice from the issuer.

Types of Callables
One factor that differentiates callable securities is the type of embedded option. Our example had an American option, the type that is continuously callable. The issuer may redeem the bond at the specified price at any time during the call period. Another type is a Bermudan option, which gives the issuer the right to call the bond on specified dates that typically coincide with coupon dates. Finally, issuers have recently begun to structure callable securities with a European style option, a one-time call feature that is a Bermudan option with only one call date. The most flexible of the options is the American, which gives the issuer maximum flexibility in timing the call decision. Callables with this type of embedded option will be the least expensive. Bermudan options are slightly more restrictive with their schedule of call dates. The European option limits the issuer to only one call date, giving the investor increased call protection. European style callables can be easily synthesized using bullet securities and over-the-counter options. Bermudan and American options embedded in callable securities actually represent a package of options that are conditional in nature. For example, with a Bermudan callable security, if the issuer calls the issue on the first call date, the remaining options on subsequent coupon dates naturally disappear. A Bermudan or American

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option cannot be exactly synthesized by selling a strip of options in the derivatives market because the package of individual options would be more expensive than the conditional option that is embedded in the callable security. The complex nature of the embedded option, where an issuers call decision is globally determined, requires a more sophisticated valuation.2 Another important feature of callable securities is the lockout period, the period during which the security cannot be called (time to call). Coupled with the time to maturity, the lockout period helps to determine the value of the embedded options. Time to call matters primarily due to the increasing dispersion of future rates the farther into the future one looks. For example, the embedded option in a 10-year noncall 6 month (10nc6M) European callable is a six-month European option on a 9 1/2-year security; the embedded option in a 10nc3 European callable is a 3-year European option on a 7-year security. The uncertainty associated with 7-year rates three years hence is larger than the uncertainty associated with 9 1/2-year rates six months from now. This rise in perceived volatility increases the expected payoff of the longer dated option, making the option more expensive. In addition, differences in the lockout period can alter the risk characteristics of the security. In particular, different lockout/maturity structures will expose the investor to different yield spreads and volatilities along the curve. This variation can prove useful for investors who are fine-tuning a curve view along with a view on volatility. For Bermudan and American style options, the impact of the lockout period is more complicated. The 10nc6M European callable is exposed to the uncertainty in the 9 1/2-year rate 6 months from now. The American and Bermudan style callables are exposed to the uncertainty in a number of forward rates. For example, the Bermudan 10nc6M callable would be exposed to the 9 -year rate 6 months forward, the 9-year rate 1 year forward, and so on including the 6-month rate 9 years forward. In this case, the set of options embedded in the
2Term structure models that use a lattice of interest rates are typically employed. Lattices are required to compute the expected value of the securitys cash flows based on the evolution of the term structure. The necessary expectation is computed using a risk-neutral probability distribution and the method of iterated expectations called backward diffusion. Lehman Brothers uses a proprietary interest rate model, incorporating mean-reversion and time-varying volatility, which is calibrated to the yield and credit curves as well as a set of liquid volatility instruments.

shorter dated lockout contains the options embedded in longer dated lockouts; the option value would be higher for the shorter dated lockout. In the case of Bermudan and American callables, the 10nc3M and 10nc3 have more in common than their European counterparts because of overlapping exposure to forward rates and volatility.

Premiums versus Discounts

In addition to the maturity/lockout structure, investors must consider the relative strikes of the embedded options compared to where forward rates are trading. In other words, investors must consider whether the options are in the money (ITM), at the money (ATM), or out of the money (OTM). Premium securities, which trade above par, generally trade on a yield-to-call basis given the likelihood that the issue will be called. This implies that the option is in the money because it will likely be exercised. Discount callables, priced below par with a coupon below the going market rate, have embedded options that are out of the money. The option sold by the callable investor is important because different options have exposure to different risks. Premium securities are exposed to extension risk. If rates back up, the option is worth less as the security becomes less likely to be called. In effect, this increases the duration of the security, extending the effective maturity beyond what the investor may have expected. Conversely, discount callables trade like bullets to maturity and are exposed to compression risk. If rates rally, the securities will shorten in duration as they become more likely to be called. A security that is trading near par is usually associated with options that are at the money, which implies that the strike price is close to the forward price of comparable bullets. But this is not necessarily true. For example, new issue European callables are usually priced and callable at par. However, the amount the option is in the money depends on both the nominal spread and the slope of the bullet curve.3 Flatter curves imply lower forward yields relative to spot yields, which implies that the option will move farther into the money holding
3It can be shown that B = N - (Ym - Yc) * Tc/(Tm-Tc) , where B is the number of bp the option is in the money, N is the nominal spread, Tc is the time to call, Tm is the time to maturity, Yc is the bullet yield to the call date, and Ym is the bullet yield to the maturity date. If the nominal spread does not change but the curve flattens instantaneously (i.e., Ym-Yc gets smaller), the option moves farther in the money. Nominal spreads for new issues tend to adjust as the shape of the curve changes.

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nominal spreads constant. Investors should compare the coupon they are receiving to forward rates imputed from the issuers credit curve. Callable securities are exposed, in varying degrees, to extension and compression risk, which affect performance. As rates decline and the security is called early, the investor receives the principal back instead of continuing to receive the higher coupon. That is, the investor has to reinvest cash flows at a lower market yield than the original stated yield. If the market sells off and rates rise, the investor is holding a longer maturity note at below market rates. The decline in duration as rates rally (or increase as rates rise) is a characteristic of negative convexity. Negative convexity, coupled with the dependence on volatility,4 is an important reason for the additional spread investors earn on callable securities. Whether the option is ITM, ATM, or OTM will influence the securitys sensitivities to changes in market variables. For example, callable securities that are ATM have the most sensitivity to changes in market rates and implied volatility. This is because the gamma and vega of an option are highest when it is at the money. As the security moves deep into or out of the money, it trades more like a bullet with little optionality. Given the lower uncertainty and hedging costs the investor faces, nominal spreads will tend to tighten to equal duration bullets. Many times investors can find relative value in premium and discount callable securities in the secondary market.

A close correlation exists between the market level, proxied by the new issue 10-year bullet yield, and the nominal spread of the callable. This is because as the option moves farther into the money, the risks associated with the option decline. That is, the options delta goes to one and its gamma goes to zero, which reduces hedging costs. In addition, model misspecifications, such as uncertainty in volatility, are less egregious when the option is deep in or out of the money. Last year, premium callables performed well versus duration-matched bullets, due to both a decline in implied volatility and a flattening of the yield curve, which caused the securities to trade more securely to call. The general behavior of nominal spreads for different callables and market changes is shown in Figure 4.

PERFORMANCE AND STRATEGIES

Sensitivities
One way to analyze the performance of callable securities is to look at their risk due to changes in the underlying variables, such as volatility or yield curve changes.

Figure 3.

Nominal Spread of FNMA 8.5 of 2/1/05-00 to Duration-matched Bullets, and New Issue 10-year Bullet Yield,
January 31, 1995-November 30, 1997
Spread (bp) New Issue IssueYield Yield Nom. Spreads Agency Spread

Yield (%)

Nominal Spreads
We next analyze how nominal spreads behave under different market conditions. Shown in Figure 3 is the nominal spread of the FNMA 8.5 of 2/1/05-00, which was an original $1 billion global 10nc5 issue. The spread is shown to the risk-weighted yield of a bullet portfolio consisting of FNMA 8.35 of 11/10/99 and FNMA 7.875 of 2/24/05. The callable, which was issued at par, quickly became a premium and its effective duration declined rapidly. Originally quoted at a spread over the 10-year Treasury, it began trading to call when yields rallied 100-150 bp.

8.5 8.0 7.5 7.0 6.5 6.0 5.5 1/31/95

60 50 40 30 20 10 0

7/31/95

1/31/96

7/31/96

1/31/97

7/31/97

Figure 4.
4In particular, for a one factor model of the short-term interest rate, it can be shown that two securities with equal duration will satisfy the following relation: 2 (C1 - C2) = 2 - 1 where is the volatility of the short rate, Ci is the convexity, and i is the time value (theta) of the security. Thus, if C 1 < C 2 then 2 < 1. Securities with negative convexity should have positive carry versus positively convex securities of equal duration, and the spread is proportional to the amount of short rate volatility.

General Behavior of Nominal Spreads* for Changes in Market Level

OTM

Rally Backup

ATM

ITM

*Callable - Duration matched bullet yield.

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Figure 5 highlights new issue callables ranging from 2-year (noncall 3 months) to 10-year (noncall 5-year) as of 12/11/97. A number of statistics are shown starting with the quoted yield to maturity (bid side) at the close of 12/11/97. The forward yields for agency bullets are shown corresponding to the first call date and the remaining maturity. For example, for the 10nc1 callable, the 9-year rate one year forward was 6.2%, which was 81 bp below the coupon of the new callable issue. Thus, the option embedded in the 10nc1 callable security is fairly deep in the money. Even though the securities are priced at par, the amount that the options are in the money varies widely. The 2nc1 callable is at the money for the most part, and generally the short-dated lockouts have options that are deeper in the money. For simplicity, we ignored the later dated embedded options beyond the initial call date, which are slightly less in the money given the upward sloping curve. Options that are trading far from the strike tend to trade at a higher implied volatility (producing what is called the volatility smile); therefore, it is important to consider the quoted yield and the reference forward yield. The option-adjusted duration (OAD) for each security as well as partial durations with respect to key points of the yield curve are shown. Partial durations or key rate durations are computed by shifting a particular sector of the yield curve and examining the price change, holding
Figure 5.
Yield Fwd Yld OADur PV01 1Y PV01 2Y PV01 3Y PV01 5Y PV01 10Y Vega

all other inputs constant. This is a convenient method for determining the risk profile of the different securities and offers more information than the pure OAD, which assumes the curve moves in parallel. For example, the 10nc3 has a fair amount of risk in the 10-year but changes to the 3-year also have an impact on performance. This is due to the fact that forward rates drive the callables performance and both the 3- and 10-year rates contribute to the 7-year rate three years forward. To determine the overall price change due to a nonparallel shift in the curve, we multiply each of the partial durations by the amount that sector of the curve moved, in bp, and add the results. Since the partial durations are expressed in basis point price change per basis point yield change, dividing by 100 gives the price change per $100 notional. For example, if the 3-, 5-, and 10-year rallied by 5 bp, 10 bp, and 15 bp, respectively, the 10nc3 callable would gain about point in price: [(-5 x -1.32) + (-10 x -0.87) + (-15 x -2.35)]/100 = 0.507. Figure 6 shows comparable statistics for bullet securities. With a modified duration of 4.3 years, the 5-year bullet has nearly the same parallel interest rate exposure as the 10nc3 callable security, which has an OAD of 4.6 years. However, examining the partial durations reveals that their exposures to different sectors of the yield curve are very different. In particular, going long the 10nc3 callable versus the 5-year bullet expresses a

Indicative Data and Risk Statistics for Selected New Issue Agency Callables, as of close 12/11/97
2nc3m 5.95 5.86 0.70 -0.21 -0.38 0.00 0.00 0.00 -2.91 2nc1 5.89 5.89 1.40 -0.56 -0.79 0.00 0.00 0.00 -2.30 5nc6m 6.48 6.01 1.60 -0.29 -0.24 -0.26 -0.88 0.00 -9.30 5nc2 6.40 6.08 3.00 -0.02 -0.81 -0.45 -1.65 0.00 -8.96 10nc1 7.01 6.20 3.00 -0.46 -0.29 -0.28 -0.48 -1.46 -19.50 10nc3 6.77 6.27 4.60 -0.05 -0.04 -1.32 -0.87 -2.35 -19.62 10nc5 6.60 6.33 5.60 -0.04 -0.05 -0.11 -2.42 -3.09 -15.70

PVO1=price value of 1 bp change.

Figure 6.
Maturity: Yield OADur PV01 1Y PV01 2Y PV01 3Y PV01 5Y PV01 10Y

Indicative Data and Risk Statistics for Selected New Issue Agency Bullets, as of close 12/11/97
0.25 yrs. 5.80 0.20 -0.06 0.00 0.00 0.00 0.00 0.5 yrs. 5.81 0.50 -0.23 0.00 0.00 0.00 0.00 1 yrs. 5.75 1.00 -0.90 0.00 0.00 0.00 0.00 2 yrs. 5.85 1.90 -0.02 -1.78 0.00 0.00 0.00 3 yrs. 5.90 2.70 0.00 -0.03 -2.67 0.00 0.00 5 yrs. 5.99 4.30 -0.01 -0.01 -0.05 -4.20 0.00 10 yrs. 6.16 7.40 -0.05 -0.02 -0.07 -0.08 -7.12

PVO1=price value of 1 bp change.

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curve flattening view in the 3- to 10-year sector of the curve holding all else constant. Duration is useful for describing price changes for relatively small changes in yields over short periods; however, care should be used in extrapolating results. Figure 7 shows partial durations for 10nc3 callable securities with different dollar prices, representing discount, par-priced, and premium securities. The discount, with a coupon of 5%, has embedded options that are out of the money. It trades to maturity due to its lower likelihood of being called, and most of the interest rate risk is embedded in the 10-year sector of the curve. This highlights a recurring theme: as rates rise and the callable extends in duration, the investment is lengthening in a bear market compared to a comparable duration bullet. Callables offer an attractive yield over bullets chiefly because as rates move in either direction, the spread over bullets, which is compounding in time, erodes in value. The other component of risk highlighted in Figure 5 is the impact of volatility on callable securities. Vega refers to the change in price, in bp, for a 1% change in implied volatility. In general, callable securities with longer dated lockouts have more exposure to changes in volatility; however, as the lockouts get longer than about three years, the vega exposure of a callable security declines. This is due to mean reversion: interest rates tend to vary randomly but are pulled toward a central location, or mean. In other words, when rates are very high there is a better chance they will decline than rise further and vice versa. Mean reversion helps to explain why yields on longer maturity securities are typically less volatile.

Figure 8.

Total Return Performance for Callables versus Duration-matched Bullets,

As of 12/22/97; 3-month annualized return

bp

75 25 -25 -75 -125 -175 -225 -100 10nc5-ATM 10nc3-ITM

-75

-50

-25

25

50

75

100

Yield Change (bp)

the FNMA 6.4 of 12/26/07-02 versus the FHLB 6.69 of 9/6/05, both of which have an effective duration of 5.88 years. Given the coupon of the callable security, the embedded options are close to being at the money. The 10nc3 performance curve illustrates a premium callable, the FNMA 7.49 of 2/7/07-00, versus the FNMA 6.59 of 5/24/01 with a duration of 3.05 years. The dollar price for the premium callable is 101-29+ (as of 12/22/97) highlighting the fact that the options are in the money by about 120 bp. Total returns are shown as a three-month return annualized as a function of yield changes, holding all other inputs constant. Although not apparent from the figure, the expected payoff from both strategies is near zero. For the 10nc5-ATM strategy, the performance curve is fairly symmetric and is similar to the performance of a buy-sell-buy butterfly trade or selling an option straddle. This is typical of a strategy that is short convexity. As discussed in the previous section, being long a callable security versus the durationmatched bullet has a risk profile similar to a barbell versus a bullet. The 10nc5-ATM has an effective convexity of -48 versus 21 for the bullet, resulting in a net convexity of -69. As the market rallies the position becomes short the market, and the investor would need to purchase additional bullet securities to return to market neutral. This is an important aspect of hedging callable securities. As the market moves, the investor has to decide either to rehedge the position or to take on the market risk due to duration drift. Frequent rehedging can be costly and locks in any losses incurred.

Total Returns and Strategies

Figure 8 shows the performance of two callable strategies compared to investing in duration-matched bullets. The performance curve for the 10nc5 security was for

Figure 7.

Partial Durations for 10nc3 Callables as a Function of Dollar Price

90.92 5.00 -0.04 -0.04 -0.29 -0.65 -5.03 100.00 6.77 -0.05 -0.04 -1.32 -0.87 -2.35 104.72 8.00 -0.06 -0.07 -1.89 -0.62 -1.24

Price: Coupon PV01 1Y PV01 2Y PV01 3Y PV01 5Y PV01 10Y

PVO1=price value of 1 bp change.

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The 10nc3-ITM strategy has an asymmetric performance profile, outperforming the 10nc5-ATM strategy in a bullish environment but faring worse if rates rise significantly. With embedded options that are in the money, the risk of ITM callables is that the option could move closer to being ATM. The duration of the callable changes the most as the option moves closer to being at the money. As yields increase, this exacerbates the duration mismatch that occurs as the callable is lengthening faster than the bullet security. When rates rally, however, the duration of the callable is more stable since its effective duration is already close to that of a bullet to call (1.91 years), which acts as a lower bound. The underperformance of the 10nc3-ITM strategy in a bearish environment is the reason for the additional 34 bp of annualized return the investor receives over the next three months if the curve remains unchanged. This example shows that callable securities can offer an attractive way for informed investors to enhance returns according to their views on rates and volatility. Premium callables should be used when the bullish investor believes that rates are unlikely to rally very far. Discount or OTM callables are a better choice when the investor wants to sell volatility but prefers more protection in a bearish environment. Time, or the expected investment period, also plays a critical role in the decision to buy callables or bullet securities. Figure 9 shows the performance of the 10nc3-ITM strategy versus the duration-matched bullet

for two holding periods. In this example, the returns are unannualized for the three-month holding period to facilitate comparison. As time passes and yields remain stable, the investor is rewarded with the additional spread that callables earn. However, for longer holding periods there is a higher probability of larger rate moves. It is this trade-off that investors must consider carefully. For example, if the investor has the view that rates may well be volatile in either direction over the near term but are likely to remain range bound over the next year, an investment in callable securities can substantially enhance returns. The performance of callable securities in nonparallel yield shifts is shown in Figure 10. The flattening and steepening curves are chosen holding one extreme of the yield curve constant with the other end moving by 25 bp. For example, in the BullFlat scenario, the 30-year rallies 25 bp and the short end remains constant. The intermediate points of the curve are interpolated via duration. Although this picture is not entirely realistic, it shows how the callables will perform in nonparallel shifts to the yield curve. In general, for any 25 bp twist in the curve, callables tend to outperform with the most improvement in a curve flattening environment. For larger curve twists, callables would underperform. The best environment for the 10nc3-ITM premium callable is a limited bullish flattener; bearish steepeners tend to hurt premium callables the most. This is indicated by net performance of -11.6 bp compared to a parallel 25 bp back-up in rates. Investors who have a limited bullish-flattening view should consider premium callables, whereas investors concerned about a significant steepening of the yield curve within a range-bound

Figure 9.
Return (bp)

Impact of Time on 10nc3-ITM Callable versus Duration-matched Bullet,

As of 12/22/97; 3-month annualized return

60 40 20 0 -20 -40 -60 -100

3 Months 1 Year

Figure 10. Callable Performance for Nonparallel Curve Shifts, in bp

Constant Dwn 25 bp Up 25 bp BullFlat BullSteep BearFlat BearSteep 10nc5-ATM 17.6 1.6 8.4 14.0 6.4 28.4 -1.2 Net* 12.4 4.8 20.0 -9.6 10nc3-ITM 52.0 39.2 31.6 64.4 34.8 62.8 20.0 Net* 25.2 -4.4 31.2 -11.6

-75

-50

-25

25

50

75

100

Yield Change (bp)

*Net of parallel shift performance.

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scenario should consider discount or at-themoney callables.

deep in the money, are attractive for investors who wish to sell volatility but are concerned about a significant move to the upside. This report introduces callable securities, defines terminology, examines the behavior of nominal spreads, highlights the risk factors, and looks at the return structure for various callable structures. But this report only begins the discussion of evaluating callable securities. Future topics include the impact of changes in implied volatility and the choice of liquid volatility products for analyzing callables. Different hedging techniques are of paramount importance and also must be explored.

CONCLUSION
Callable securities are an attractive way for investors to express their views on the likely range of rates, market direction, and changes in the slope of the yield curve. Available securities offer a diversity in price and structure that allows investors an opportunity to sculpt the payoff distribution that is most desirable. For example, premium callables, with embedded options

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