Explanation

Correct Answer: C

Key Concepts:

1. Callable Bond (Bond 1): Gives the issuer the right to call (redeem) the bond before maturity. This option benefits the issuer, not the investor. To compensate investors for this disadvantage, callable bonds typically offer higher yields (and thus larger nominal yield spreads) compared to otherwise identical non-callable bonds.

2. Putable Bond (Bond 2): Gives the investor the right to put (sell back) the bond to the issuer before maturity. This option benefits the investor, providing protection against rising interest rates or credit deterioration. Because this option is valuable to investors, putable bonds typically offer lower yields (and thus smaller nominal yield spreads) compared to otherwise identical non-putable bonds.

3. Plain Vanilla Bond (Bond 3): Contains no embedded options.

Analysis of the Manager's Statement: The manager claims that both Bond 1 (callable) and Bond 2 (putable) should have larger nominal yield spreads than Bond 3 (non-callable, non-putable).

• For Bond 1 (callable): This is correct - callable bonds should have larger spreads to compensate investors for the call risk.
• For Bond 2 (putable): This is incorrect - putable bonds should have smaller spreads because the put option benefits the investor, making the bond more valuable.

Therefore, the manager is NOT correct because Bond 2's nominal yield spread should be less than Bond 3's, not larger.

Yield Spread Relationship:

• Callable bond spread > Non-callable bond spread
• Putable bond spread < Non-putable bond spread
• Non-callable, non-putable bond spread is in between

Why Option C is Correct: The manager's statement is incorrect specifically because Bond 2 (putable) should have a smaller yield spread than Bond 3, not a larger one. Option C correctly identifies this specific error in the manager's reasoning.