Callable Bond Definition, How It Works, and How to Value

A callable bond exposes an investor to “reinvestment risk,” or the risk of not being able to reinvest the returns generated by an investment. Investors are the lenders, giving money to businesses who promise to make interest payments to the investor. If the bond is callable, the issuer can call them back and pay the investor their principal plus any interest earned to that point. Investors can use bond valuation models to estimate the fair value of callable bonds, taking into account factors such as interest rates, credit rating, and call features. Common models include the Black-Scholes-Merton model and the binomial interest rate tree model.

  1. In weaker economic conditions, issuers may face higher borrowing costs and be less likely to call their bonds.
  2. Callable bonds are debt securities issued by corporations or governments that grant the issuer the right to redeem the bonds before maturity.
  3. Additionally, when interest rates increase more than the market rate, companies would keep the bonds till their maturity rate since they would be financing themselves with lower interest payments.

Issuers usually issue bonds with a call feature to raise money in a safer way in which they can call the bonds when interest rates go down and issue new ones with lower interest payments. Conversely, your bond will appreciate less in value than a standard bond if rates fall and might even be called away. Should this happen, you would have benefited in the short term from a higher interest rate. However, you would then have to reinvest your assets at the lower prevailing rates. In this example, they would likely have been better off buying Firm A’s standard bond and holding it for 30 years.

Unlike callable bonds, non-callable ones cannot be redeemed before maturity. Callable bonds tend to offer higher coupon rates to compensate for the call risk, whereas non-callable bonds usually have lower coupon rates. Callable bonds typically have higher coupon rates compared to non-callable bonds, making them attractive for investors seeking higher yields. To determine whether to invest in callable bonds, you need to consider the right mix of stocks vs. bonds in your portfolio. Even though callable bonds offer a slightly higher yield than noncallable bonds, stocks are typically a much bigger driver of growth in your portfolio.

Higher-rated issuers are less likely to default, resulting in lower perceived risk and a lower coupon rate. The call price is the amount that the issuer must pay to redeem the bond before its maturity date. It is typically expressed as a percentage of the bond’s face value and may include a call premium to compensate investors for the early redemption. Investors typically receive a higher yield on callable bonds compared to similar non-callable bonds as compensation for the risk of early redemption. 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.

Corporations repay the principal amount back to investors on the bonds maturity date, which is the expiration date for the bond. Companies issue bonds to finance their activities and compensate investors with interest payments paid callable bonds definition each period until the maturity date. Interest rates play a significant role in determining whether a bond will be called early or not. However, since a callable bond can be called away, those future interest payments are uncertain.

These bonds are referred to as “callable bonds.” They are fairly common in the corporate market and extremely common in the municipal bond market. Callable bonds can be used to manage a portfolio’s duration and reduce its sensitivity to interest rate changes. Investors can create a portfolio with a more stable duration profile by including callable bonds with different call dates and call protection periods. In a strong economy, issuers may have improved credit ratings and access to lower borrowing costs, making it more attractive to call their bonds. Multi-callable bonds can be called on multiple specified dates, giving issuers even more flexibility in managing their debt obligations.

Analyzing Callable Bonds

As a result, investors will receive higher interest payments than standard bonds throughout the bond’s life. That is why investment in such bonds is never a bad idea for investors, and obviously, the same goes for companies demanding funds. Callable Bonds, also known as redeemable bonds, are special types of bonds that can be called early by the issuing company and retrieved from the bondholder before reaching maturity. These bonds usually offer higher interest rates due to their callable features. Callable bonds may be beneficial to the bond issuers if interest rates are expected to fall. In such a case, the issuers may redeem their bonds and issue new bonds with lower coupon rates.

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. In other words, the bond would likely be called only when it’s advantageous for the corporation, meaning interest rates have moved lower. 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. Reinvestment risk, though simple to understand, is profound in its implications.

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.

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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. 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.

Disadvantages of Callable Bonds

For example, consider two 30-year bonds issued by equally creditworthy firms. Assume Firm A issues a standard bond with a YTM of 7%, and Firm B issues a callable bond with a YTM of 7.5% and a YTC of 8%. On the surface, Firm B’s callable bond seems more attractive due to the higher YTM and YTC.

Advantages of Callable Bonds

Economic conditions can influence the likelihood of callable bonds being redeemed. Investors may receive higher coupon rates as compensation for the increased call risk. Bermuda callable bonds combine features of both European and American callable bonds.

Callable Bond: Definition & How It Works

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. Thus, the issuer has an option which it pays for by offering a higher coupon rate. They are less in demand due to the lack of a guarantee of receiving interest payments for the full term. Therefore, issuers must pay higher interest rates to persuade people to invest in them.

However, that’s not always the case, as sometimes high yield refers to increasing dividends on a falling stock. For example, the bond may be issued at a par value of 1000$, and a company would pay 1040$ when they call the bond. Callable bonds have two potential life spans, one ending at the original maturity date and the other at the call date. 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. A financial professional will offer guidance based on the information provided and offer a no-obligation call to better understand your situation. The articles and research support materials available on this site are educational and are not intended to be investment or tax advice.

With a callable bond, investors have the benefit of a higher coupon than they would have had with a non-callable bond. On the other hand, if interest rates fall, the bonds will likely be called and they can only invest at the lower rate. This is comparable to selling (writing) an option — the option writer gets a premium up front, but has a downside if the option is exercised. As a general rule of thumb in investing, it is best to diversify your assets as much as possible. Callable bonds are one tool to enhance the rate of return of a fixed-income portfolio. On the other hand, they do so with additional risk and represent a bet against lower interest rates.

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