A:

Bond issues can contain what is referred to as a call provision, which is a right afforded to the issuing company enabling it to refund the bondholder the par value of his/her bond (perhaps including a small call premium) at the company's discretion. Any and all call provisions applicable to a bond issue will be included in the bond issue's indenture, so be sure you understand the details of the indenture for the bond you are buying.

Most of today's corporate debentures are callable bonds, and about 70% of municipal bonds are callable too - so if you are interested in trading bonds, you should understand how they work.

Call provisions contain several specific rules which apply to the issuer and the bondholder. First, there will generally be a waiting period, starting immediately after the bond issue is offered, during which the company cannot call the bond. This provides the bondholder with a guaranteed length of time he/she will be able to hold the bond. Next, call provisions also specify the price at which the company must buy the bonds back from the bondholders, should it choose to call the issue. This price is usually set at the bond's par value plus a small premium.

Given the structure of call provisions, firms generally call bonds in situations where interest rates have declined since the bonds were first issued. Why? Because they can then buy back their debt at about par value (which will be lower than market value when interest has fallen) and refinance their debt at lower interest rates. Generally, the investor would prefer to hold on to his/her bond, or at least sell it at the higher market price; unfortunately, once a bond issue is called, the investor must accept the call price specified in the bond's indenture. Primarily for this reason, bond investors generally do not like call provisions. However, most bond issues do contain call provisions because most companies receive strong value from them, as they allow a firm to refinance at lower interest rates when they are available.

Generally, callable bonds offer slightly higher interest rates than non-callable bonds as consideration for this flexibility.

(For further reading, see Call Features: Don't Get Caught Off Guard.)

RELATED FAQS
  1. What risk factors should investors consider before purchasing a callable bond?

    Understand the difference between callable and non-callable bonds and consider all the various risk factors associated with ... Read Answer >>
  2. Why do companies issue callable bonds?

    Learn how callable bonds work, how they include an embedded call option, and understand the additional risks that callable ... Read Answer >>
  3. What are the risks of investing in a bond?

    The most well-known risk in the bond market is interest rate risk - the risk that bond prices will fall as interest rates ... Read Answer >>
  4. What does it mean when a bond has a put option?

    A put option on a bond is a provision that allows the holder of the bond the right to force the issuer to pay back the principal ... Read Answer >>
  5. What determines the price of a bond in the open market?

    Learn more about some of the factors that influence the valuation of bonds on the open market, and why bond prices and yields ... Read Answer >>
Related Articles
  1. Investing

    Six Biggest Bond Risks

    Don't assume that you can't lose money in this market - you can. Find out how.
  2. Investing

    5 Basic Things To Know About Bonds

    Learn these basic terms to breakdown this seemingly complex investment area.
  3. Investing

    Guide To Embedded Options In Bonds

    Investors should be aware of embedded options that may be available in certain securities as these options may affect the value of the security.
  4. Investing

    5 Reasons to Invest in Municipal Bonds When the Fed Hikes Rates

    Discover five reasons why investing in municipal bonds after the Fed hikes interest rates, and not before, can be a great way to boost investment income.
  5. Investing

    How To Evaluate Bond Performance

    Learn about how investors should evaluate bond performance. See how the maturity of a bond can impact its exposure to interest rate risk.
  6. Investing

    The Best Bet for Retirement Income: Bonds or Bond Funds?

    Retirees seeking income from their investments typically look into bonds. Here's a look at the types of bonds, bond funds and their pros and cons.
  7. Financial Advisor

    Advising FAs: Explaining Bonds to a Client

    Most of us have borrowed money at some point in our lives, and just as people need money, so do companies and governments. Companies need funds to expand into new markets, while governments need ...
  8. Investing

    Corporate Bonds: Advantages and Disadvantages

    Corporate bonds can provide compelling returns, even in low-yield environments. But they are not without risk.
RELATED TERMS
  1. Call Risk

    The risk, faced by a holder of a callable bond, that a bond issuer ...
  2. Call Privilege

    The provision in a bond indenture that gives the bond issuer ...
  3. Bond

    A debt investment in which an investor loans money to an entity ...
  4. European Callable Bond

    A bond that can be redeemed by the issuer at a predetermined ...
  5. Dollar Price

    The percentage of par, or face value, at which a bond is quoted. ...
  6. Bond Yield

    The amount of return an investor will realize on a bond. Several ...
Hot Definitions
  1. Five Cs Of Credit

    A method used by lenders to determine the credit worthiness of potential borrowers. The system weighs five characteristics ...
  2. Straddle

    An options strategy in which the investor holds a position in both a call and put with the same strike price and expiration ...
  3. Trickle-Down Theory

    An economic idea which states that decreasing marginal and capital gains tax rates - especially for corporations, investors ...
  4. North American Free Trade Agreement - NAFTA

    A regulation implemented on Jan. 1, 1994, that eventually eliminated tariffs to encourage economic activity between the United ...
  5. Agency Theory

    A supposition that explains the relationship between principals and agents in business. Agency theory is concerned with resolving ...
  6. Treasury Bill - T-Bill

    A short-term debt obligation backed by the U.S. government with a maturity of less than one year. T-bills are sold in denominations ...
Trading Center