What is a Callable Bond?
A callable bond is a bond that can be redeemed by the issuer prior to its maturity. If interest rates have declined since the company first issued the bond, the company is likely to want to refinance this debt at the lower rate of interest. In this case, the company "calls" its current bonds and reissues them at a lower interest rate.
A callable bond is also referred to as a redeemable bond.
Understanding a Callable Bond
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. For example, a bond maturing in 2030 can be called in 2020. A callable, or redeemable, bond is typically called at an amount slightly above par value; the earlier a bond is called, the higher its call value. For example, a bond callable at a price of 102 brings the investor $1,020 for each $1,000 in face value, yet stipulations state the price goes down to 101 after a year.
Advantages of Callable Bonds
A callable bond pays an investor a higher coupon than a non-callable bond. The issuer has flexibility in payment amount and loan length when borrowing money from an investor. Issuing a bond lets a corporation borrow at a lower interest rate than a bank loan, saving the company money.
For example, a corporation decides to borrow $10 million in the bond market and issues a 6% coupon bond with a maturity date five years from now. The company pays its bondholders 6% x $10 million = $600,000 in interest payments annually. Three years from the date of issuance, interest rates fall by 200 basis points 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 = $408,000.
Disadvantages of Callable Bonds
Bonds are usually called when interest rates fall. This exposes the investor to reinvestment risk, which involves reinvesting the principal at a lower interest rate. For example, 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 = $600 annually. Three years after issuance, the interest rate drops to 4%, and the bond is called by the issuer. The bondholder must turn in the bond to get back the principal, and no further interest is paid. The bondholder not only loses the remaining interest payments, but may be unable to match a bond that pays 6% in the current 4% interest rate environment. The investor might choose to reinvest at a lower interest rate and lose potential income.
To reduce its cost of borrowing, when interest rates fall, the issuer will call its bonds from the market and have them reissued at the lower interest rate. When a company reissues a bond at a lower interest rate, the bond costs the investor more than when it was originally issued. The company can call a bond at a price below the market price. The price of a callable bond will not be much higher than its call price, as lowering interest rates mean calling the bond is likely. When analyzing potential returns for a callable bond, an investor must consider the yield-to-call (YTC) and yield-to-maturity (YTM) to ensure the potential income matches his objectives. A callable bond may not be appropriate for an investor seeking regular income and predictable returns.
Types of Call Features
Optional redemption lets an issuer redeem its bonds when it chooses. For example, a municipal bond has call features that may be exercised after a set time period, typically 10 years. Sinking fund redemption requires the issuer to adhere to a set schedule while redeeming a portion or all of its bonds. 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 means a set time where the bond cannot be called. The issuer must clarify whether a bond is callable and the exact terms of the call option, including when it can be redeemed and what the price will be when the bond is first sold.