A Callable bond allows the issuer to repurchase the bond before maturity at a stated price known as the call price. This call feature is included in almost all corporate bond issues and is mentioned in the bond indenture.
A callable bond basically allows the entity issuing it to pay off its debt earlier than expected. Businesses may opt to call their bonds early if interest rates decline, enabling them to re-finance their debt at a more favorable rate. Callable bonds usually offer more attractive coupon rates or interest rates so that to compensate investors against the re-investment risk they get exposed to due to the callable nature of such bonds.
How Does A Callable Bond Work?
A callable bond can be described as a debt instrument that provides its issuer the right to return the principal amount and stop the interest payments before the bond’s scheduled maturity. Companies may issue bonds to expand their operations or to pay off their existing loans. If the business entities expect the interest rates to decline in the near future then they may opt for issuing callable bonds, providing them with an opportunity to redeem the bonds early in case interest rates decline and then re-finance debt at lower rates. The bond’s offering will mention all the terms and conditions associated with the calling of the bond by its issuer.
A redeemable or callable bond is usually called at a price that is a little above the debt’s face value. The earlier a bond is called in its life span, the higher will be its call value. For example, a bond having a face value of $100 with scheduled maturity in 2025 can be called three years earlier in 2022. The callable price of one such bond maybe $120. This price means that the investor will receive $1,200 for each $1,000 invested. The call price of the bond may go down to $110 after a year.
Types of Callable Bonds
Bonds that can be called come with a lot of variations. Optional redemption allows the issuer to redeem its bond in accordance with the terms and conditions agreed at the time of the bond’s issuance. However, all bonds are not callable such as treasury notes and treasury bonds but there are quite a few exceptions. Some corporate bonds and most municipal bonds are callable. For example, the call feature of a municipal bond may be exercised after a specific period such as 5 years.
It refers to the period in which the bonds cannot be called. The issuer of the bond must provide clarification on whether a bond can be called and the exact terms and conditions of the call option, including the time period in which the bond is eligible for call.
Interest Rates and Callable Bonds
If interest rates available in markets decline after a company issues a bond, the company can issue a new bond that offers a lower rate of interest than compared to one offered by the original callable bond. The company may use the proceeds from the second bond issue (the one with a lower interest rate) to pay off the first callable bond by utilizing the call feature. This would help the company in refinancing its debt by redeeming the callable bond having the higher interest rate and buying the newly issued bond at a lower and more attractive rate.
Paying debt early by exercising the option of calling bonds before the scheduled maturity date allows a company to save its expense. However, the holder of a bond having the call feature may suffer in case the issuer exercises the call feature.
For example, a company issues a 5% interest rate bond that will mature in four years. An investor buys $5,000 worth of bonds and receives interest payments of $250 (5% x $5,000) annually. Two years after the bond has been issued by the company, the interest rates available in markets fall to 3%, and the issuer exercises the option to call the bond. The bondholder will hand over the bond to the issuer and in turn, would receive the principal amount and no further interest payment. The principal amount, in this case, is $5,000.
Pros and Cons of a Callable Bond
Some of the pros of a callable bond are as follows:
- Pays higher interest or coupon rate
- Helps businesses in raising capital
- The call feature provides the investor the option to refinance its debts by recalling the bond
Some of the cons of a callable bond are as follows:
- Investors cannot take advantage when interest or coupon rates rise in markets
- Investors are required to replace high interest rate bonds with lower interest rate bonds.