What affect does market volatility have on the probability of a callable agency bond getting called?

Question

if vol. decreases, does it increase the probability that a callable agency bond will get called?

Answer 1

Increases in volatility add value to both puts and calls. This is not exactly the same as increasing the probability of being called.

For a callable bond where the option is out of the money, increasing volatility will increase the probability of it being called.

For a callable bond where the option is at the money, increasing the volatility does not change the probability of being called -- however, it does increase the expected benefit given that it gets called. That is -- it does not increase the probability that it will move into the money -- but given that it moves into the money, it should increase the payoff.

For a callable bond that is already in the money, increasing the volatility actually decreases the probability of being called -- but increases the likely payoff given that it is called. To illustrate this point, suppose that the bond is in the money and volatility drops to zero -- then it will stay where it is and be called with certainty. On the other hand, if volatility increases, it could make a big move out-of-the-money -- and not be called.

Answer 2

Callable bonds are called when the rates go up in which case the company need pay only less.