A callable bond is a unique type of investment bond that can be redeemed prior to it’s maturity date. It’s a flexible investment vehicle that can offer unique benefits for investors who wish to utilize it.
Summary
- A callable bond can be redeemed early by the issuer before its maturity date.
- Allows businesses to redeem the bonds and borrow at lower interest rates.
- Callable bonds have call protection periods.
What is a Callable Bond?
A callable bond, also commonly referred to as a “redeemable bond”, is a bond that an issuer can “redeem” before its maturity date. The bond gives allows the issuing company to pay off their debt obligations earlier. A major reason that businesses may choose to redeem their bonds earlier is due to a change in interest rates.
If interest rates move lower it can allow businesses to borrow at a more favorable rate. As a result of having the ability to redeem the bonds, callable bonds usually have higher interest rates than other types of bonds.
How Callable Bonds Work?
If you’re a business and decide to issue callable bonds to investors to raise capital, you have the option to return the investor’s money and cease payments before the bond’s maturity date. Big corporations can issue bonds to fund and expand their operations or use the money as they see fit.
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If interest rates change and decrease, a callable bond gives the business the right to return investor money before the bond matures to borrow at lower rates. The bond agreement outlines the terms and conditions and at which cycle a company can redeem the bond.
Callable Bond Pricing and Interest Rates
If interest rates go down after a company issues a bond, the company has the option to issue new debt at a lower interest rate than the original bond that they issued. After the company secures funding from the new bond issue, they will use the funds to pay off the original bond through redemption.
It’s a way for the company to refinance their debt at a lower interest rate, much like you would with a standard mortgage refinance. Paying off the debt by redeeming the bond will save the company interest expense and can help improve a company’s financials.
Bond investors need to know how callable bonds work because their investment returns can be negatively impacted. Due to the fact that callable bonds are redeemable, will have a value that is slightly above the par value associated with the debt.
Callable Bond Example
Let’s assume we have a bond that is maturing in 2025 and the bond can be called back in 2021. The bond may show a callable price value of 103. This means that the investors will receive $1,030 for each $1,000 in face value of their investment.
In addition to this, the bond agreement can stipulate that the early call price can go down to 102 or 101 after the first or second year.
Different Types of Callable Bonds
There are many different types of callable bonds and they can all come with their own stipulations and rules. Some callable bonds have strict redemption periods and as an investor it’s important to be aware of them.
- Treasury bonds are usually non-callable, but there are be exceptions depending on the issuer.
- Corporate bonds are callable and can have certain stipulations which outline the redemption periods and the rate adjustments. The redemption periods will depend on the maturity date of the bond.
- Municipal Bonds are also callable and will also have their own stipulations in regards to the redemption periods and how much of the loan amount can be redeemed. It won’t always be the full amount and will depend on the agreement.
Important: It’s important to note that callable bonds will have call protection periods. These are periods in which the bond cannot be redeemed.
Call protection periods will be in the bond agreement. As an investor, it’s important to know when these periods are so you can adequately prepare.
Example of Callable Bond
Microsoft decides to borrow $10 million by issuing callable bonds at a 5% interest rate with a maturity date in 3 years. Investors will receive $500,000 in interest annually.
One year from the date of the debt issue, interest rates fall to 4% and Microsoft decides to “redeem” the bonds. Under a bond agreement, if the company redeems the bonds, it is required to pay investors $103 premium to par. As a result, Microsoft has to pay investors $10.3 million, which it can get from the bank at 4% interest rate.
Microsoft decides to take advantage of the lower interest rates and reissues the debt at a 4% interest rate and pays back investors $10.3 million. By calling the bonds back, Microsoft reduces the cost of their debt by 1%.
Not that Microsoft would really ever need to borrow money, but you can the picture.
Advantages Disadvantages of Callable Bonds
Callable bonds hold redemption risk for investors. As such, they tend to pay higher than average coupon rates when compared to standard bonds that are non-callable. They are meant to benefit companies when interest rate environments change in their favor.
Although callable bonds sounds great in theory, they do hold some disadvantages. A company can redeem the bonds if interest rates fall. This exposes investors to investment risk because their level of return will be lower as a result of the redemption. Subsequently, when interest rates increase, investors can be left holding an investment which has a smaller ROI than what the current market offers.
Lastly, businesses that issue these bonds have to offer them at higher coupon rates in order to attract investors. The nature of callable bonds poses risk to investors. As a result, companies have to make them more appealing in order to raise capital. The higher than average coupon rate for businesses increases the overall cost associated with borrowing money which in turn impacts how much money a company can pour into their operations.
Advantages
- Callable bonds offer higher interest rates to investors
- Flexible options for the issuer of the debt
- Allows businesses to raise capital quickly
- They allow companies to take advantage of lower interest rates
Disadvantages
- Callable bonds post a risk to investors because their investment returns could potentially be lower in the future
- The cost to borrow capital is higher for companies issuing callable bonds
- If the market rises, investors can be stuck with lower interest rate
