What Is an American Callable Bond?
An American callable bond, also known as continuously callable, is a bond that an issuer can redeem at any time prior to its maturity. Usually, a premium is paid to the bondholder when the bond is called. A callable bond is also called a redeemable bond since the issuer can redeem it early.
- An American callable bond, also known as continuously callable, is a bond that an issuer can redeem at any time prior to its maturity.
- American callable bonds pose considerable reinvestment risk to bondholders.
- American callable bonds typically pay a higher yield than noncallable bonds of the same maturity and credit quality.
Understanding American Callable Bonds
A bond is a debt instrument in which corporations issue to investors to raise money for projects, to purchase assets, and to fund the expansion of the business. Bonds are sold to investors in which the corporation gets paid the principal amount or the face value of the bond.
In return, investors typically get paid interest payments, called coupon payments, throughout the life of the bond. Corporations repay the principal amount back to investors on the bonds maturity date, which is the expiration date for the bond.
Corporate bonds can have many types of features, one of which is a call provision, which allows the corporation to repay the principal back to the investor before the bond's maturity date. When an issuer calls its bonds, it pays investors the call price (usually the face value of the bonds) together with accrued interest to date and, at that point, stops making interest payments.
Most corporate bonds contain an embedded option giving the borrower or corporation the option to call the bond at a pre‐specified price on a date of their choosing. Calls are not mandatory and thus may or may not be redeemed. Since investors might have their callable bond redeemed before maturity, investors are compensated with a higher interest rate when compared to the traditional, noncallable bonds.
Since a bond is an IOU to investors, a callable bond essentially allows the issuing company to pay off its debt early.
Why American Callable Bonds Get Called
Corporations redeem American callable bonds early for various reasons, and investors should be aware of whether it's likely their bond will be called.
A business may choose to call their bond if market interest rates move lower, which would allow them to refinance at a lower rate. A company, for example, might have a five-year bond outstanding that pays investors 4% per year. Let's say that two years after issuing the bond that overall interest rates fall and the current five-year bonds can be issued for a 2% interest rate.
The corporation can call the American callable bond and pay back the investors their principal as well as any interest owed up to that point. The company can issue new five-year bonds at the current 2% interest rate and cut their interest expense on their bonds by 50%. The transactions can be done simultaneously so that the funds from the new issues go to paying the existing investors that are holding the callable bonds.
In addition to its callable bonds, a company might have a loan outstanding with a bank. The company might want to increase the loan amount, or if no loan exists, get approved for a new loan. A bank might stipulate that the company reduce its debt before it can get approved for the loan or an extension of an existing credit line. Before a bank lends to a corporation, they will analyze the company's financial statements, revenue outlook, profitability, and the amount of debt a company is carrying on its balance sheet.
The company needs to be able to service all of its debt, including the new loan or extension that the company is looking to receive. In other words, the corporation needs to have enough revenue and cash flow from its operations to be able to make the principal and interest payments on its debts. The interest payments on callable bonds are part of the cost of the company's debt.
As a result, a bank may require a company to reduce or payback its callable bonds, particularly if the bond's interest rate is high. Eliminating the interest payments from the callable bonds reduces the company's debt servicing costs and can put them in a better position to obtain a loan or better terms for their loan, such as a lower interest rate.
Risks of American Callable Bonds
Corporations can redeem American callable bonds early without the investor's consent. As a result, investors should not only be aware of the scenarios in which a bond is likely to be called, but also the risks posed to investors from an early redemption.
Unfortunately, callable bonds pose considerable reinvestment risk to bondholders, who face the prospect of reinvesting the proceeds of a called bond at lower interest rates that generate less interest income. In other words, the bond would likely be called only when it's advantageous for the corporation, meaning interest rates have moved lower.
Using the earlier example, if an investor has a 4% bond that's redeemed early and the company offers a replacement bond, but at a rate of 2%, the investor's rate of return will be 50% lower going forward. The risk that the bond is called and the investor is stuck with a lower, less attractive interest rate is called reinvestment risk. The investor might have been better off buying a noncallable bond at the onset, which paid a rate of 3% rate for five years. However, it depends on when the bond gets called and how long the investor has earned the higher-than-typical rate from the callable bond.
Also, since the issuer can call the bond at any time before maturity, there is also uncertainty as to when the call (and corresponding interest rate exposure) will occur. This unconstrained ability of an issuer to call back their bonds is the primary difference between American callable bonds and European callable bonds, which can be called at a predetermined date prior to maturity.
Credit Quality Risk
As stated earlier, investors can earn a higher yield with callable bonds because of the callable feature. However, investors need to also be compensated for any added risk due to a lack of a company's credit quality, which involves the quality of the company issuing the bond. The bond being issued is only as good as the company's ability to repay the bond.
If a high-yield, callable bond is being issued, it might be a red flag that the company can't find any buyers for a traditional, noncallable bond. Investors must do their due diligence to determine whether the company has the financial stability to be able to repay the principal payments to the investors by the bond's maturity date.
Risk vs. Return
As a result, investors need to weigh the risk versus the return when buying callable bonds. It's true that the interest rate should be higher for callable bonds. However, the rate needs to be high enough to compensate for the added risk of it being called, and the investor is stuck earning a lower rate for what would be the remaining term of the bond. Investors should consider other fixed-rate noncallable bonds and whether it's worth buying a callable or some combination of both callable and noncallable bonds.
American Callable Bonds vs. Other Callable Bonds
In addition to American and European callable bonds, bonds can be offered with the following options:
- Bermuda Call: The issuer has the right to call a bond on interest payment dates only, starting on the first date the bond is callable.
- Canary Call: Callable by a predetermined call schedule up to a period of time, then either called or converted to a bullet structure moving forward.
- Make-Whole Call: A call that when exercised by the issuer and provides an investor with a redemption price that is the greater of the following:
- The price that corresponds to the specific yield spread over a stated benchmark, such as a comparable U.S. Treasury security (plus accrued interest)
Example of a Callable Bond
Bank of America Corporation (BAC) issued a press release on July 2, 2020, stating that the company would redeem on July 21, 2020, all $1 billion in principal amount outstanding of its Floating Rate Senior Notes, which have a maturity date in July of 2021. A senior note is a type of bond that takes precedence over other bonds and debts if the company declares bankruptcy. A floating-rate note is a bond that pays investors a variable interest rate, meaning the rate can change as overall interest rates change.
Below is the statement from Bank of America's press release regarding the early redemption of its senior notes:
The redemption price for each series of the Senior Notes will be equal to 100% of the principal amount of such series, plus accrued and unpaid interest to, but excluding, the redemption date of July 21, 2020. Interest on each series of the Senior Notes will cease to accrue on the redemption date.