The primary circumstance under which a bond issuer redeems a callable bond is a drop in interest rates. When rates fall, it makes no sense for the bond issuer to continue paying higher-than-average interest to investors when a provision in the bond allows for redemption before its maturity. After calling the high-interest bonds, the issuer can raise capital again by issuing new bonds at a lower interest rate.
A bond is a way for a business or government entity to raise money and for an investor to receive a guaranteed return. The investor provides capital to the issuer in exchange for a series of fixed-interest payments over a defined term. At the end of the term, the issuer returns the investor's principal.
For example, consider an investor who purchases a $10,000 bond at 9% interest with a 20-year term. First he pays $10,000 to the issuer, which the latter can use as capital. Over the next 20 years, the investor receives fixed payments of $900 per year, or 9% of the bond's face amount. When the 20 years are over, the bond issuer returns the investor's $10,000 principal.
With a callable bond, also known as a redeemable bond, the issuer is not required to make interest payments to the investor for the bond's full term. If it wishes, it can call, or redeem, the bond early. Upon redeeming the bond, the issuer must return the investor's principal payment.
Bond issuers redeem callable bonds when interest rates experience a big drop. When rates fall, issuers of callable bonds have two choices: They can keep the bonds active and pay higher-than-market interest rates to investors, or they can redeem the bonds and cease making those interest payments.
Returning to the bond example above, if market interest rates drop from 9% to 4% after five years and the bond is callable, the issuer can redeem it, return the investor's $10,000 and then reissue bonds at an interest rate that is now 5% lower. Instead of making $900 yearly interest payments on a $10,000 bond, the issuer now has the luxury of making only $400 interest payments.
Many investors avoid callable bonds precisely because of this provision. After all, bonds are popular because they provide guaranteed interest for a given term, and a callable feature takes that guarantee away. To entice people to invest in callable bonds, issuers typically offer them at a higher interest rate than is paid by comparable bonds without a callable feature. For an investor to receive higher-than-market interest on a bond, he usually has to pay a bond premium – more than face amount for the bond. But callable bonds offer a higher rate while still being available at face value.