What are Callable Bonds?

A callable bond (also called redeemable bond) is a type of bond (debt security) that allows the issuer of the bond to retain the privilege of redeeming the bond at some point before the bond reaches its date of maturity. In other words, on the call date(s), the issuer has the right, but not the obligation, to buy back the bonds from the bond holders at a defined call price. Technically speaking, the bonds are not really bought and held by the issuer but are instead cancelled immediately.

The call price will usually exceed the par or issue price. In certain cases, mainly in the high-yield debt market, there can be a substantial call premium.

Thus, the issuer has an option which it pays for by offering a higher coupon rate. If interest rates in the market have gone down by the time of the call date, the issuer will be able to refinance its debt at a cheaper level and so will be incentivized to call the bonds it originally issued. Another way to look at this interplay is that, as interest rates go down, the present values of the bonds go up; therefore, it is advantageous to buy the bonds back at par value.

With a callable bond, investors have the benefit of a higher coupon than they would have had with a non-callable bond. On the other hand, if interest rates fall, the bonds will likely be called and they can only invest at the lower rate. This is comparable to selling (writing) an option — the option writer gets a premium up front, but has a downside if the option is exercised.

The largest market for callable bonds is that of issues from government sponsored entities. They own many mortgages and mortgage-backed securities. In the U.S., mortgages are usually fixed rate, and can be prepaid early without cost, in contrast to the norms in other countries. If rates go down, many home owners will refinance at a lower rate. As a consequence, the agencies lose assets. By issuing numerous callable bonds, they have a natural hedge, as they can then call their own issues and refinance at a lower rate.

The price behaviour of a callable bond is the opposite of that of puttable bond. Since call option and put option are not mutually exclusive, a bond may have both options embedded.

How a Callable Bond Works

A callable bond is a debt instrument in which the issuer reserves the right to return the investor’s principal and stop interest payments before the bond’s maturity date. Corporations may issue bonds to fund expansion or to pay off other loans. If they expect market interest rates to fall, they may issue the bond as callable, allowing them to make an early redemption and secure other financings at a lowered rate. The bond’s offering will specify the terms of when the company may recall the note.

A callable—redeemable—bond is typically called at a value that is slightly above the par value of the debt. The earlier in a bond’s life span that it is called, the higher its call value will be. For example, a bond maturing in 2030 can be called in 2020. It may show a callable price of 102. This price means the investor receives $1,020 for each $1,000 in face value of their investment. The bond may also stipulate that the early call price goes down to 101 after a year.

How to find the value of a callable bond?

Valuing callable bonds differs from valuing regular bonds because of the embedded call option. The call option negatively affects the price of a bond because investors lose future coupon payments if the call option is exercised by the issuer.

The value of a callable bond can be found using the following formula:

Price (Callable bond) = Price (Plain – Vanilla Bond) - Price (Call Option)

Where:

• Price (Plain – Vanilla Bond) – the price of a plain-vanilla bond that shares similar features with the (callable) bond.
• Price (Call Option) – the price of a call option to redeem the bond before maturity.

Types of Callable Bonds

Callable bonds come with many variations. Optional redemption lets an issuer redeem its bonds according to the terms when the bond was issued. However, not all bonds are callable. Treasury bonds and Treasury notes are non-callable, although there are a few exceptions.

Most municipal bonds and some corporate bonds are callable. A municipal bond has call features that may be exercised after a set period such as 10 years.

Sinking fund redemption requires the issuer to adhere to a set schedule while redeeming a portion or all of its debt. On specified dates, the company will remit a portion of the bond to bondholders. A sinking fund helps the company save money over time and avoid a large lump-sum payment at maturity. A sinking fund has bonds issued whereby some of them are callable for the company to pay off its debt early.

Extraordinary redemption lets the issuer call its bonds before maturity if specific events occur, such as if the underlying funded project is damaged or destroyed.

Call protection refers to the period when the bond cannot be called. The issuer must clarify whether a bond is callable and the exact terms of the call option, including when the timeframe when the bond can be called.

Callable Bond Risks

Buying a callable bond may not appear any riskier than buying any other bond. But there are reasons to be cautious. A callable bond exposes an investor to “reinvestment risk,” or the risk of not being able to reinvest the returns generated by an investment.

Investors achieve a small level of safety with bonds by locking in a desirable interest rate. A call not only throws a wrench into their investment plans, it means they have to buy another investment to replace it. Commissions or other fees add to the cost of acquiring another investment—not only did the investor lose potential gains, but they lost money in the process.

Here’s an example—the Federal Reserve cuts interest rates, and the going rate for a 15-year, AAA-rated bond falls to 2%. Your bond issuer may decide to pay off the old bonds issued at 4% and reissue them at 2%.

As the investor, you will receive the original principal of the bond, but you will have difficulty reinvesting that principal and matching your initial 4% return. You can either buy a lower-rated bond to obtain a 4% return or buy another AAA-rated bond and accept the meager 2% return.

Examine the prospectus of the bonds you’re interested in to find out if they’re callable before you purchase them.

Bond market insiders know that one of the most common mistakes that novice investors make is to buy a callable bond on the secondary or over-the-counter market as rates are falling. The experienced investors know the “call date”—the day on which an issuer has the right to call back the bond—is approaching, and are selling to avoid the call.

They sell the bonds to the new investors, who believe they have found a great deal. The buyer may pay a principle of $1,000 plus a commission—and then promptly discover that the bond is called. That investor will receive the $1,000 back, but not the commission. It is money lost, and there is no recourse for the investor.

Should You Buy a Callable Bond?

Buying any investment requires that you weigh the potential return against potential risk. For entry-level investors, callable bonds may be too complex to consider. For example, the prices of callable bonds in the secondary market move quite differently from other bonds’ prices.

When interest rates fall, most bond prices rise, but callable bond prices fall when rates fall—a phenomenon called “price compression.” However, callable bonds offer some interesting features for experienced investors. By calculating a callable bond’s yield-to-call, investors can plan for a call and use it to their advantage.

Callable Bonds and Interest Rates

If market interest rates decline after a corporation floats a bond, the company can issue new debt, receiving a lower interest rate than the original callable bond. The company uses the proceeds from the second, lower-rate issue to pay off the earlier callable bond by exercising the call feature. As a result, the company has refinanced its debt by paying off the higher-yielding callable bonds with the newly-issued debt at a lower interest rate.

Paying down debt early by exercising callable bonds saves a company interest expense and prevents the company from being put in financial difficulties in the long term if economic or financial conditions worsen.

However, the investor might not make out as well as the company when the bond is called. For example, let’s say a 6% coupon bond is issued and is due to mature in five years. An investor purchases $10,000 worth and receives coupon payments of 6% x $10,000 or $600 annually. Three years after issuance, the interest rates fall to 4%, and the issuer calls the bond. The bondholder must turn in the bond to get back the principal, and no further interest is paid.

In this scenario, not only does the bondholder lose the remaining interest payments but it would be unlikely they will be able to match the original 6% coupon. This situation is known as reinvestment risk. The investor might choose to reinvest at a lower interest rate and lose potential income. Also, if the investor wants to purchase another bond, the new bond’s price could be higher than the price of the original callable. In other words, the investor might pay a higher price for a lower yield. As a result, a callable bond may not be appropriate for investors seeking stable income and predictable returns.

What are the Pros of a Callable Bond?

The advantages that an investor and an issuer can derive from callable bonds are –

• High-value

Callable bonds provide a higher value to investors than other fixed-income instruments. This makes it a lucrative option for investors looking to enhance the earning potential of their portfolio without assuming high-risk like that of equities.

• Fixed stream of income

It provides investors with a sure stream of income for the period that it is held. That, combined with a higher interest rate, makes it a more profitable option compared to standard bonds.

• Flexible financing option

Companies can leverage their call option anytime outside the call protection period. This eases the obligation of serving a debt at higher coupon rates when market interest rates are low.

What are the Cons of a Callable Bond?

The disadvantages it presents to investors and issuers are –

• Replacement with a low-income instrument

When callable bonds are redeemed, investors may need to shift to a low-income debenture or assume higher risk by investing in stocks. Either way, it’s a compromise.

• Servicing a higher rate

Issuers need to incur a higher cost with callable securities than they would have had to with a vanilla bond. This increases the overall expense of projects financed through such callable bonds.

From an investor’s perspective, therefore, callable bonds are ideal if they want to earn higher returns than a traditional fixed-income instrument while agreeing with the uncertainty of redemption before maturity.

Final Thoughts

Callable bonds provide several benefits to issuers and investors. Investors would receive higher coupon payments for reinvestment and interest rate factors. At the same time, issuers can call these bonds when they receive lower interest rates in the market.