DEFINITION of Callable Security
A callable security is a security with an embedded call provision that allows the issuer to repurchase or redeem the security by a specified date. Since the holder of a callable security is exposed to the risk of the security being repurchased, the callable security is generally less expensive than comparable securities that do not have a call provision.
Callable securities are commonly found in the fixed-income markets and allow the issuer to protect itself from overpaying for debt.
BREAKING DOWN Callable Security
A bondholder expects to receive interest payments on his or her bond until the maturity date, at which point the face value of the bond is repaid. The coupons paid represent interest income to the investor. However, there are some fixed income securities that are callable, the conditions of which are established in the trust indenture at the time the security is issued. Issuers of callable securities have the right to redeem the bonds prior to their maturity dates, especially during times when interest rates in the markets decrease. When interest rates decrease, borrowers or issuers have an opportunity to refinance the terms of the bond coupon rate at a lower interest rate, thereby, reducing their cost of borrowing. When bonds are “called” before they mature, interest will no longer be paid to the investors.
To give investors some time to take advantage of any appreciation in the value of the bonds, callable securities have a provision known as a call protection. As the name implies, a call protection protects bondholders from having their securities called by issuers during the early stages of a bond’s life. Call protection can be extremely beneficial for bondholders when interest rates are falling, because it prevents the issuer from forcing an early redemption on the security. This means that investors will have a minimum number or years to reap the benefits of the security.
For example, assume a callable corporate bond was issued today with 4% coupon and a maturity date set at 15 years from now. If the call protection on the bond is ten years, and interest rates go down to 3% in the next five years, the issuer cannot call the bond because its investors are protected for ten years. However, if interest rates decline after ten years, the borrower is within its rights to trigger the call option provision on the bonds.
The trust indenture also lists the date(s) a bond can be called early after the call protection period ends. This date is referred to as the call date. There could be one or a number of call dates during the life of the bond. The call date that immediately follows the end of the call protection is called the first call date. The series of call dates is known as a call schedule and for each of the call dates, a particular redemption value is speciﬁed. An issuer may redeem its existing bonds on the call date if interest rates are favorable. If rates and yields rise enough, issuers will likely choose to not call their bonds until a later call date or simply wait until the maturity date to refinance.
To compensate callable security holders for the reinvestment risk they are exposed to and for depriving them of future interest income, issuers will pay a call premium. The call premium is an amount over the face value of the security and is paid in the event that the security is redeemed before the scheduled maturity date. Put another way, the call premium is the difference between the call price of the bond and its stated par value. For noncallable securities or for a bond redeemed early during its call protection period, the call premium is a penalty paid by the issuer to the bondholders.
During the first few years a call is permitted, the premium is generally equal to one year's interest. Depending on the terms of the bond agreement, the call premium gradually declines as the current date approaches the maturity date. At maturity, the call premium is zero.