A:

Companies issue callable bonds to allow them to take advantage of a possible drop in interest rates at some point in the future. The issuing company can redeem callable bonds prior to the maturity date according to a schedule of callable dates identified in the bond’s terms. If interest rates decrease, the company can redeem the outstanding bonds and reissue the debt at a lower rate, thereby reducing the cost of capital. It is similar to a mortgage borrower refinancing at a lower rate. The prior mortgage with the higher interest rate is paid off, with the borrower obtaining a new mortgage with the lower rate.

The bond often defines the callable amount to recall the bond that may be greater than the par value. The price of bonds has an inverse relationship with interest rates. Bond prices go up as interest rates fall. Thus, it is advantageous for a company to pay off debt by recalling the bond at above par value. Callable bonds are more complex investments than normal bonds. They may not be appropriate for risk-averse investors seeking a steady stream of income.

Investors are paid a premium interest rate as compensation for the additional risk of a callable bond. Owners of callable bonds risk the bond being called. If that happens, they will be forced to invest in other bonds at a lower rate. The bond investor is essentially writing an option on the bond. The investor receives the premium for the written option up front, but risks having the option exercised and the bond called.

Investors in callable bonds need to track two yields, unlike a normal bond with only one yield. Callable bonds have a yield-to-call and a yield-to-maturity. The yield-to-call is the amount the bond will yield before it has the possibility of being called. The yield-to-maturity is the expected rate of return on a bond if it is held until maturity. It takes into account the bond’s market value, the par value, the coupon interest rate and the time to maturity. The yield-to-maturity considers the time value of money, whereas a simple yield calculation does not. Both yields should be acceptable to an investor before he buys them. If interest rates do ultimately decline, the value of callable bonds will not increase as much as normal bonds. In this scenario, the likelihood of the bond being called increases, and there is less investor demand for these bonds.

There are different types of call options embedded in callable bonds. An American call allows the issuer to recall the bond at any time after the callable date. In this case, the bond is known as continuously callable. For European calls, the issuer only has the right to call the bond on a specific date. This is known as a one-time only call. Callable bonds may offer attractive premiums over normal bonds, but investors need to understand their risks.

RELATED FAQS
  1. What are the accounting entries when a company issues a callable bond?

    Learn how callable bonds are treated on balance sheets, and understand why callable bonds often pay investors a premium for ... Read Answer >>
  2. 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 >>
  3. Why doesn't the price of a callable bond exceed its call price when interest rates ...

    A callable bond provides the issuer (borrowing entity) with an option to redeem the bond before its original maturity date. ... Read Answer >>
  4. Under what circumstances might an issuer redeem a callable bond?

    Understand why an interest rate drop usually compels bond issuers to redeem callable bonds and re-issue them at the new, ... Read Answer >>
  5. A corporate bond I own has just been called by the issuer. How can a company legally ...

    Bond issues can contain what is referred to as a call provision, which is a right afforded to the issuing company enabling ... Read Answer >>
  6. What causes a bond's price to rise?

    Learn about factors that influence the price of a bond, such as interest rate changes, credit rating, yield and overall market ... Read Answer >>
Related Articles
  1. Investing

    Callable Bonds: Leading A Double Life

    Find out more about these dangerous and exciting cousins to regular bonds.
  2. Investing

    Callable Bond

    Find out how callable bonds are different from regular bonds and what benefits they have for investors.
  3. Investing

    Bond Call Features: Don't Get Caught Off Guard

    Learn why early redemption occurs and how to avoid potential losses.
  4. 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.
  5. Investing

    Six Biggest Bond Risks

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

    Corporate Bond Basics: Learn to Invest

    Understand the basics of corporate bonds to increase your chances of positive returns.
  7. Investing

    An Introduction to Individual Bonds

    Individual bonds are better than bond funds and can be a key component to one’s investment strategy.
  8. Investing

    Investing in Bonds: 5 Mistakes to Avoid in Today's Market

    Investors need to understand the five mistakes involving interest rate risk, credit risk, complex bonds, markups and inflation to avoid in the bond market.
  9. Investing

    The Basics Of Bonds

    Bonds play an important part in your portfolio as you age; learning about them makes good financial sense.
RELATED TERMS
  1. American Callable Bond

    A bond that can be redeemed by the issuer at any time prior to ...
  2. Prepayment Risk

    Prepayment risk is the risk associated with the early unscheduled ...
  3. Bond Yield

    The amount of return an investor will realize on a bond. Several ...
  4. Pre-Refunding Bond

    A type of bond issued to fund another callable bond, where the ...
  5. Discount Bond

    A bond that is issued for less than its par (or face) value, ...
  6. Doubling Option

    A sinking fund provision that gives a bond issuer the right to ...
Hot Definitions
  1. Salvage Value

    The estimated value that an asset will realize upon its sale at the end of its useful life. The value is used in accounting ...
  2. Cryptocurrency

    A digital or virtual currency that uses cryptography for security. A cryptocurrency is difficult to counterfeit because of ...
  3. Promissory Note

    A financial instrument that contains a written promise by one party to pay another party a definite sum of money either on ...
  4. SEC Form 13F

    A filing with the Securities and Exchange Commission (SEC), also known as the Information Required of Institutional Investment ...
  5. Fixed Asset

    A long-term tangible piece of property that a firm owns and uses in the production of its income and is not expected to be ...
  6. Absolute Advantage

    The ability of a country, individual, company or region to produce a good or service at a lower cost per unit than the cost ...
Trading Center