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 a lower rate of interest. In this case, the company calls its current bonds and reissues them at a lower rate of interest.
A callable bond means the issuer can 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 callable slightly above par value; the call value increases the earlier a bond is called. 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. Most municipal bonds and some corporate bonds are callable.
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.
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.
Disadvantages of Callable Bonds
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 bondholder must turn in the bond to get back the principal; no further interest is paid. An investor might reinvest at a lower interest rate and lose potential income. 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. An investor must consider the yield-to-call (YTC) and yield-to-maturity (YTM) when analyzing potential returns for a callable bond to ensure potential income matches his objectives. A callable bond may not 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 set portion or all of its bonds. Extraordinary redemption lets the issuer call its bonds before maturity if specific events occur, like if the underlying project is damaged or destroyed.