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What Is a Callable Bond?
A callable bond, also known as a redeemable bond, is an investment option that allows issuers to pay off their debt early before the bond’s maturity date. Corporations may choose to call these bonds when interest rates drop, thereby re-borrowing at more favorable rates. This flexibility means that callable bonds usually offer higher interest rates to investors compared to non-callable bonds.
Key Takeaways
- A callable bond allows the issuer to redeem it before its maturity, often to refinance at lower interest rates.
- These bonds typically offer higher coupon rates to compensate investors for the risk of being called early.
- Callable bonds favor issuers in declining interest rate environments, but can expose investors to reinvestment risk.
- Various types of callable bonds exist, including those with options for extraordinary redemption and sinking fund provisions.
- When interest rates drop, companies save on interest expenses by replacing high-interest callable bonds with lower-rate debt.
Understanding the Mechanism of Callable Bonds
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. If they expect market interest rates to fall, they may issue the bond as callable, allowing them to make an early redemption and secure other financings at a lowered rate. The bond’s offering will specify the terms of when the company may recall the note.
A callable—redeemable—bond is typically called at a value that is slightly above the par value of the debt. The earlier in a bond’s life span that it is called, the higher its call value will be. For example, a bond maturing in 2030 can be called in 2020. It may show a callable price of 102. This price means the investor receives $1,020 for each $1,000 in face value of their investment. The bond may also stipulate that the early call price goes down to 101 after a year.
Exploring Different Types of Callable Bonds
Callable bonds come with many variations. Optional redemption lets an issuer redeem its bonds according to the terms when the bond was issued. However, not all bonds are callable. Treasury bonds and Treasury notes are non-callable, although there are a few exceptions.
Most municipal bonds and some corporate bonds are callable. A municipal bond has call features that may be exercised after a set period such as 10 years.
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. A sinking fund has bonds issued whereby some of them are callable for the company to pay off its debt early.
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.
Call protection refers to the period when the bond cannot be called. The issuer must clarify whether a bond is callable and the exact terms of the call option, including when the timeframe when the bond can be called.
Influence of Interest Rates on Callable Bonds
If market interest rates decline after a corporation floats a bond, the company can issue new debt, receiving a lower interest rate than the original callable bond. The company uses the proceeds from the second, lower-rate issue to pay off the earlier callable bond by exercising the call feature. As a result, the company has refinanced its debt by paying off the higher-yielding callable bonds with the newly-issued debt at a lower interest rate.
Paying off debt early with callable bonds helps a company save on interest and avoid future financial troubles if conditions worsen.
However, the investor might not make out as well as the company when the bond is called. For example, let’s say a 6% coupon bond is issued and is due to mature in five years. An investor purchases $10,000 worth and receives coupon payments of 6% x $10,000 or $600 annually. Three years after issuance, the interest rates fall to 4%, and the issuer calls the bond. The bondholder must turn in the bond to get back the principal, and no further interest is paid.
In this scenario, not only does the bondholder lose the remaining interest payments, but it would be unlikely they will be able to match the original 6% coupon. This situation is known as reinvestment risk. Investors might have to reinvest at a lower rate and potentially pay more for a new bond with a lower yield than the original. As a result, a callable bond may not be appropriate for investors seeking stable income and predictable returns.
Weighing the Pros and Cons of Callable Bonds
Callable bonds typically pay a higher coupon or interest rate to investors than non-callable bonds. The companies that issue these products benefit as well. Should the market interest rate fall lower than the rate being paid to the bondholders, the business may call the note. They may then refinance the debt at a lower interest rate. This flexibility is usually more favorable for the business than using bank-based lending.
Not all features of callable bonds are positive. Issuers often call bonds when rates drop, forcing investors to reinvest at lower returns. On the other hand, rising rates can leave investors with lower returns on tied-up funds. Finally, companies must offer a higher coupon to attract investors. This higher coupon will increase the overall cost of taking on new projects or expansions.
Pros
- Pay a higher coupon or interest rate
- Investor-financed debt is more flexibility for the issuer
- Helps companies raise capital
- Call features allow recall and refinancing of debt
Cons
- Investors must replace called bonds with lower rate products
- Investors cannot take advantage when market rates rise
- Coupon rates are higher raising the costs to the company
Example of a Callable Bond
Let’s say Apple Inc. (AAPL) decides to borrow $10 million in the bond market and issues a 6% coupon bond with a maturity date in five years. The company pays its bondholders 6% x $10 million or $600,000 in interest payments annually.
Three years from the date of issuance, interest rates fall by 200 basis points (bps) to 4%, prompting the company to redeem the bonds.If the company calls the bonds, it pays investors a $102 premium per bond. 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.
The Bottom Line
Callable bonds offer issuers the flexibility to pay off debt early when interest rates drop, potentially reducing interest expenses. However, investors face reinvestment risk as they may need to find new investments at lower rates. While these bonds pay higher interest rates to entice investors, they also raise costs for issuers. Understanding callable bonds’ benefits and risks can guide better investment and borrowing decisions.
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