What Is a Callable Bond?

A callable bond is a bond that the issuer may redeem before it reaches the stated maturity date. In essence, a callable bond allows the issuing company to pay off their debt early. A business may choose to call their bond if market interest rates move in a favorable direction and will allow them to borrow at a more beneficial rate.

Callable bonds also benefit investors as they typically offer an attractive interest rate or coupon rate due to their callable nature. Another name for callable bonds is a redeemable bond.

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Callable Bond

Callable Bonds Explained

A callable bond is a debt instrument in which the issuer reserves the right to return the investor's principal and stop interest payments before the bond's maturity date. Corporations may issue bonds to fund expansion or to pay off other loans. If they expect market interest rates to fall, they may issue the bond as callable, allowing them to make an early redemption and secure other financings at a lowered rate. The bond's offering will specify the terms of when the company may recall the note.

A callable—redeemable—bond is typically called at a value that is slightly above the par value of the debt. The earlier in a bond's life span that it is called, the higher its call value will be. For example, a bond maturing in 2030 can be called in 2020. It may show a callable price of 102. This price means the investor receives $1,020 for each $1,000 in face value of their investment. The bond may also stipulate that the early call price goes down to 101 after a year.

Key Takeaways

  • A callable bond is one that can be redeemed early by the issuer before its maturity.
  • A callable bond allows companies to pay off their debt early and benefit from favorable interest rate moves.
  • A callable bond benefits the investor with an attractive interest or coupon rate.
  • Another name for a callable bond is a redeemable bond.

Types of Callable Bonds

Callable bonds come with many variations. Optional redemption lets an issuer redeem its bonds according to the terms when the bond was issued. However, not all bonds are callable. Treasury bonds and Treasury notes are non-callable, although there are a few exceptions.

Most municipal bonds and some corporate bonds are callable. A municipal bond has call features that may be exercised after a set period such as 10 years.

Sinking fund redemption requires the issuer to adhere to a set schedule while redeeming a portion or all of its debt. On specified dates, the company will remit a portion of the bond to bondholders. A sinking fund helps the company save money over time and avoid a large lump-sum payment at maturity. A sinking fund has bonds issued whereby some of them are callable for the company to pay off its debt early.

Extraordinary redemption lets the issuer call its bonds before maturity if specific events occur, such as if the underlying funded project is damaged or destroyed.

Call protection refers to the period when the bond cannot be called. The issuer must clarify whether a bond is callable and the exact terms of the call option, including when the timeframe when the bond can be called.

Interest Rates and Callable Bonds

If interest rates decline after a corporation floats a bond, the company can issue new debt, receiving a lower interest rate than the original callable bond. The company uses the proceeds from the second, lower-rate issue to pay off the earlier callable bond by exercising the call feature. As a result, the company has refinanced its debt by paying off the higher-yielding callable bonds with the newly-issued debt at a lower interest rate.

Paying down debt early by exercising callable bonds saves a company interest expense and prevents the company from being put in financial difficulties in the long term if economic or financial conditions worsen. 

However, the investor might not make out as well as the company when the bond is called. For example, let's say a 6% coupon bond is issued and is due to mature in five years. An investor purchases $10,000 worth and receives coupon payments of 6% x $10,000 or $600 annually. Three years after issuance, the interest rates fall to 4%, and the issuer calls the bond. The bondholder must turn in the bond to get back the principal, and no further interest is paid.

In this scenario, not only does the bondholder lose the remaining interest payments but it would be unlikely they will be able to match the original 6% coupon. This situation is known as reinvestment risk. The investor might choose to reinvest at a lower interest rate and lose potential income. Also, if the investor wants to purchase another bond, the new bond's price could be higher than the price of the original callable. In other words, the investor might pay a higher price for lower yield. As a result, a callable bond may not be appropriate for investors seeking stable income and predictable returns.

Pros

  • Callable bonds typically pay a higher coupon or interest rate to investors than non-callable bonds

  • Callable bonds benefit companies since investor-financed debt provides more flexibility than bank-issued debt

  • Callable bonds help companies raise capital that might not be available from a bank

  • Companies benefit since they refinance their debt when rates fall by exercising the call feature

Cons

  • Bonds are usually called when interest rates fall leaving exposing the investor to reinvest the principal at a lower rate

  • Investors may lose out when interest rates rise since the company is unlikely to redeem the bond

  • If a bond is called and the principal is reinvested, the new bond might have a higher price than the original

  • Companies have higher interest expenses since callable bonds pay higher rates than non-callables

Real World Example of a Callable Bond

Let's say Apple Inc. (APPL) decides to borrow $10 million in the bond market and issues a 6% coupon bond with a maturity date in five years. The company pays its bondholders 6% x $10 million or $600,000 in interest payments annually.

Three years from the date of issuance, interest rates fall by 200 basis points (BPS) to 4%, prompting the company to redeem the bonds. Under the terms of the bond contract, if the company calls the bonds, it must pay the investors $102 premium to par. Therefore, the company pays the bond investors $10.2 million, which it borrows from the bank at a 4% interest rate. It reissues the bond with a 4% coupon rate and a principal sum of $10.2 million, reducing its annual interest payment to 4% x $10.2 million or $408,000.