Bonds and Bold Callables in the Real World

This report details the construction of a new factor model to simulate callable bond prices under the real-world measure (P). It emphasizes using OA yield as an empirical anchor to capture negative convexity and OAS-driven price movements.

Key Takeaways

• 1.Using OA yield as the primary explanatory variable for callable bond price movements captures market dynamics better than using swap rates alone.
• 2.Callable bonds exhibit negative convexity, which becomes significantly more pronounced as the bond price approaches the prepayment cap.
• 3.A combined factor model accounting for both rates and OAS factors is essential to accurately model callable bond returns, as OAS-driven price moves can be material even when swap rates remain stable.

Table of Contents

• Empirical BPV fits better against OA yield than against the swap rate
• A consistent piecewise structure across bonds
• Modelling OA yield inside the factor model
• Simulated prices and returns — a 4% price-98 bond
• A high-coupon bond near the cap
• Stress: OAS factors twist up, rates stay put
• What this looks like in this year's tape
• Conclusion