Why doesn't the price of a callable bond exceed its call price when interest rates are falling?

By Richard Loth AAA
A:

A callable bond provides the issuer (borrowing entity) with an option to redeem the bond before its original maturity date. The ability to call a bond gives the issuer a way to respond to falling interest rates, a circumstance that allows the issuer to refinance this debt at a lower rate of interest.

Callable bonds often pay investors a higher interest rate than noncallable bonds to compensate for uncertainty and also may pay a premium for early termination of the investment. If a callable bond's coupon (interest rate) is higher than prevailing rates at the time of the call, investors won't be able to reinvest their capital in a comparable bond at as high a yield.

While it might seem reasonable to assume that in a declining interest rate environment a callable bond's price would exceed the bond's call price, experience tells us that this isn't a given. Investors need to know that there is a risk that the price at which the bond is redeemed could be below the bond's current price.

For more insight, read Call Features: Don't Get Caught Off Guard and What are the risks of investing in a bond?

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