Callable Bonds Explained

Callable bonds, formerly known as redeemable bonds provide the issuer with a right to redeem the bonds before its maturity date.

However, the issuer is not obliged to do the same. This sort of bond comes with a call option which has certain restrictions.

There are equal pros and cons of callable bonds. On one hand, it provides the issues with good deals if interest rates are expected to fall and on the other hand, it increases the risk of losing high interest due to prior redemption.

Such bonds come with the premium which is a result of the associated risk in order to compensate the investor.

Callable bonds are issued by companies after figuring out a downfall in the interest rates so that they can be eligible to make an early redemption in order to secure and reissue their financings.

Callable bonds are canceled immediately and not really bought back by the issuer. As the call option adds up value to the issuer, the price of a callable bond exceeds the price of a straight bond.

Because a callable bond is riskier for an investor, they often offer a high annual return to compensate for the risk of the bond being canceled or called off early.

The primary types of call features for a callable bond include optional redemption, sinking fund redemption, and extra-ordinary redemption.

Types of Callable Bonds

Apart from the explicitly stated meaning of callable bonds, they are subjected to numerous variations. There might be a few types of bonds which, instead of being callable hold a few exceptions in terms of their redemption.

An issuer is allowed to redeem its bonds as per the terms and conditions stated at the time of issuing a callable bond.

  • Bonds such as treasury bonds as well as treasury notes are subjected to a few exceptions on their terms of redemption, even though they are not callable bonds.
  • The most common sort of callable bonds includes corporate bonds and municipal bonds. Municipal bonds come with some call features which might only be accessible after a certain period of time like 10 years.

Now callable bonds might also differ on the basis of their method of redemption.

  • Sinking fund redemption allows the issuer to save up on its resources and not opt for a lump-sum payment at maturity. A portion of the amount is paid to the holders on specified dates and a sinking fund has bonds issued and some of them are callable.
  • Extraordinary redemption allows the issuer to call off or cancel its bonds before maturity only on the occurrence of some pre-specified extraordinary events.
  • Call protection is related to the time frame of calling off the bond. It requires the issuer to classify if the bonds are callable and its other terms of the time period of redemption. One cannot call the bonds when the period of call protection is going on.

Interest Rates and Callable Bonds

Now, it is important to know the relation between interest rates and callable bonds. After suspecting a decline in market interest rates, an issuer can call the amount and redeem its bonds.

This will result in a lower interest rate and the company can reissue its debt and use the proceeds from the fresh and low-interest issue to pay off the earlier callable bond calls. Ergo, the corporation is able to refinance its debt by paying off the high-yielding debt and issuing the same bonds for a lower rate of interest in the market.

For instance,

$50,000 10% coupon bond is issued with a maturity period of 4 years. An investor purchases $7000 worth of bonds and therefore the interest amount due will be $700 (10% * $7000), on an annual basis.

After two years of issue, the interest rates fall down to, let’s say 6%. This is when the issuer calls the bond and the bond is turned in by the investor and no further interest is paid by the issuer.

In this case scenario, the investor is at high risk by not only losing the interest amount but also the original 10% coupon bond. This is referred to as the reinvestment risk.

The investor might lose potential income by choosing to invest at lower interest rates. That is why a callable bond is never suggested for an investor who seeks a stable source of income and suspected and predictable outcomes. However, the issuer is at the benefit.

Pros and Cons of Callable Bonds

Pros

  1. As compared to noncallable bonds, callable bonds are subjected to a high-interest rate/coupon rate which results in a better income for the investor.
  2. Always considered as a better option for corporate to raise capital money.
  3. Re calling and financing of debt is possible due to the call feature.
  4. Benefits the companies by allowing them to call the bond amount and reissue their bonds at lower interest rates.
  5. Callable bonds offer better flexibility than traditional lending methods of raising money.

Cons

  1. As the interest rates on callable bonds are usually high, companies could find a less expensive method of raising capital.
  2. It only benefits the issuer and companies when market interest rates decline. There might be scenarios where it might get a hike.
  3. Interest rates/coupon rates add to the costs of the company taking on expansions or any new projects.
  4. The investors have additional risks and can suffer when the interest rates are tended to fall down.
  5. Does not provide a stable income to the investor.

Why do Companies like Callable Bonds
Because of the fact that they can reissue the bonds at a lower interest rate at any point of time in the future before the maturity date.

Final Words

A callable bond might be a good option for an investor who is likely to take more risks for a good interest or coupon rate because a callable bond is not expected to provide stable income.

On the other hand, corporate chains requiring huge capital requirements with flexible and easy methods might issue callable bonds. Even though the initial coupon rate is higher, it can lead to tremendous benefits when interest rates dropdown.

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