Callable Bond Definition
Why Companies Issue Bonds
Why would a company issue a callable bond?
Companies issue callable bonds to allow them to take advantage of a possible drop in interest rates at some point in the future. The issuing company can redeem callable bonds prior to the maturity date according to a schedule of callable dates identified in the bond’s terms. Bond prices go up as interest rates fall.
But the price of a callable bond will not rise much above its call price, no matter how low interest rates go, because dropping interest rates increase the likelihood that it will be called. Zero coupon bonds have a duration equal to the bond’s time to maturity, which makes them sensitive to any changes in the interest rates. Investment banks or dealers may separate coupons from the principal of coupon bonds, which is known as the residue, so that different investors may receive the principal and each of the coupon payments. Start-up businesses have a high failure rate when compared with larger, well-established firms.
What Are the Risks of Investing in a Bond?
In addition to reinvestment-rate risk, investors must also understand that market prices for callable bonds behave differently than normal bonds. Typically as rates decrease, you will see bond prices increase, but this is not the case for callable bonds.
Basic Things to Know About Bonds
However, these risks are related to decreases in interest rates and make callable bonds one of many tools for investors to express their tactical views on financial markets. (For further reading on investment diversification practices, check out Achieving Optimal Asset Allocation).
Callable bonds have a yield to call and ayield to maturity. The yield to call is the amount the bond will yield before it has the possibility of being called.
Bonds are loan agreements involving creditors and borrowers. Cities and corporations issue bonds with terms ranging from six months to 30 years. The bond issuer pays interest to the bondholders for the duration of the bond’s term.
As a result, callable bonds often have a higher annual return to compensate for the risk that the bonds might be called early. Investors in callable bonds need to track two yields—unlike a normal bond with only one yield.
This phenomenon is called price compression and is an integral aspect of how callable bonds behave. Overall, callable bonds also come with one big advantage for investors. They are less in demand due to the lack of a guarantee of receiving interest payments for the full term, so issuers must pay higher interest rates to persuade people to invest in them. Normally, when an investor wants a bond at a higher interest rate, they must pay a bond premium, meaning that they pay more than the face value for the bond.
Bonds vs. Stock
- Bonds are loan agreements involving creditors and borrowers.
- The bond issuer pays interest to the bondholders for the duration of the bond’s term.
- Cities and corporations issue bonds with terms ranging from six months to 30 years.
An issuer may choose to call a bond when current interest rates drop below the interest rate on the bond. That way the issuer can save money by paying off the bond and issuing another bond at a lower interest rate. This is similar to refinancing the mortgage on your house so you can make lower monthly payments. Callable bonds are more risky for investors than non-callable bonds because an investor whose bond has been called is often faced with reinvesting the money at a lower, less attractive rate.
A callable bond, also known as a redeemable bond, is a bond that the issuer may redeem before it reaches the stated maturity date. A callable bond allows the issuing company to pay off their debt early.
A business may choose to call their bond if market interest rates move in a favorable direction and will allow them to borrow at a more beneficial rate. Callable bonds also benefit investors as they typically offer an attractive interest rate or coupon rate due to their callable nature.
How does a callable bond work?
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. Corporations may issue bonds to fund expansion or to pay off other loans.
What Investors in Callable Bonds Need to Know
With a callable bond, however, the investor can receive higher interest payments without a bond premium. Callable bonds do not always get called; many of them pay interest for the full term, and the investor reaps the benefits of higher interest for the entire duration.
Consequently, small companies typically have to pay higher rates on loans and bonds than more established firms. Credit rating agencies regularly review the finances of bond issuers, including corporations and municipalities. Over the course of time, an entity can increase its credit rating by balancing its books and making debt payments on time. The higher an entity’s credit rating, the more cheaply and easily it can borrow money. Therefore, many start-up firms issue callable bonds so that these debts can be refinanced with lower-cost bonds once the firm has improved its credit rating.
What Is a Callable Bond?
Typically, the interest rate is fixed for the entire term. A call feature enables the bond issuer to pay off the debt prior to the end of the term. When the call feature is activated, bondholders receive a return of premium as well as any interest that has accrued. Investors usually demand higher-than-average yields on callable bonds; the additional interest offsets some of the risk associated with lost income if the bond is called in.
Callable Bonds vs. Interest Rates
Callable or redeemable bonds are bonds that can be redeemed or paid off by the issuer prior to the bonds’ maturity date. When an issuer calls its bonds, it pays investors the call price (usually the face value of the bonds) together with accrued interest to date and, at that point, stops making interest payments. Call provisions are often a feature of corporate and municipal bonds. There is no free lunch, and the higher interest payments received for a callable bond come with the price of reinvestment-rate risk and diminished price-appreciation potential.
Yield to maturity considers the time value of money, whereas a simple yield calculation does not. Issuers entice investors to buy callable bonds by paying higher interest rates on callable bonds than on noncallable bonds.