The following excerpt is taken from an article titled “Eagle Eyes High-Coupon Callable Corporates” that appeared in the January 20, 1992, issue of BondWeek, p. 7:
“If the bond market rallies further, Eagle Asset Management may take profits, trading $8 million of seven- to 10-year Treasuries for high-coupon single-A industrials that are callable in two to four years according to Joseph Blanton, Senior V.P. He thinks a further rally is unlikely, however. . . . The corporates have a 95% chance of being called in two to four years and are treated as two- to four-year paper in calculating the duration of the portfolio, Blanton said.”
Answer the below questions.
(a) Why is modified duration an inappropriate measure for a high-coupon callable bond?
(b) What would be a better measure than modified duration?
(c) Why would the replacement of 10-year Treasuries with high-coupon callable bonds reduce the portfolio’s duration?