Callable Bond: Definition and Key Features Explained US Legal Forms

That makes callable bonds one of many tools for investors to express their tactical views on financial markets and achieve an optimal asset allocation. This discourages issuers from calling bonds unless the financial benefits outweigh the cost of the make-whole payment. Investors scrutinize these terms to gauge the likelihood of early redemption.

After the call protection period, the call schedule within the bond debenture states the call dates and the call price corresponding to each date. The call price is often set at a slight premium in excess of the par value. Lyle Daly is a contributing Motley Fool stock market analyst covering information technology and cryptocurrency. His work has been featured on USA Today, Yahoo Finance, MSN, Fox Business, and Nasdaq. Before joining The Motley Fool, he wrote for financial brands including Intuit. Find out why bonds are getting a lot of attention from investors these days.

This call price is typically set at a premium to the bond’s face value to provide some compensation for the early termination. The call decision is usually triggered when market interest rates have declined substantially below the bond’s coupon rate, allowing the issuer to refinance its debt at a lower cost. Callable bonds typically pay a higher coupon or interest rate to investors than non-callable bonds. Should the market interest rate fall lower than the rate being paid to the bondholders, the business may call the note.

What are callable and non-callable bonds?

When you buy a bond, you might expect to receive interest payments over a fixed period of time and then get the face value back at the maturity date. Here, the price of the call option is the call option’s value, which allows the issuing entity to redeem a bond before maturity. The price of a standard vanilla bond is similar to that of a callable bond. A noncallable bond or preferred share that is redeemed before the maturity date or during the call protection period will incur the payment of a steep penalty. A callable, or redeemable bond is typically called at an amount slightly above par value; the earlier a bond is called, the higher its call value.

Credit rating agencies assess the likelihood of early redemption when assigning ratings, influencing both investor demand and market pricing. Make-whole call provisions are costly to exercise because they need a full lump sum payment. So, companies that use make-whole call provisions usually do so because interest rates have fallen. When rates have decreased or are trending lower, a company has an added incentive to exercise make-whole call provisions. If interest rates have dropped, then issuers of corporate bonds can issue new bonds at a lower interest rate.

The firm can call the bond if interest rates decrease to 5% in year 5 and issue new bonds at a reduced rate, thus saving money. 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. Paying off debt early with callable bonds helps a company save on interest and avoid future financial troubles if conditions worsen. 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. This price means the investor receives $1,020 for each $1,000 in face value of their investment.

The “call price” is the predetermined amount the issuer pays to redeem the bond, often its par value plus a premium. For instance, a bond issued at $1,000 might have a call price of $1,020, meaning investors receive $20 above face value if called. The “call date(s)” specify when the issuer can exercise this right, as outlined in the bond’s prospectus. Different types of callable bonds offer varying redemption features, each designed to meet specific issuer needs while providing distinct investment opportunities. Call provisions frequently include protection periods during which the bond cannot be called, providing you with a guaranteed minimum investment period. After this period, the bond becomes callable according to a predetermined schedule.

• However, if the interest rate increases or remains the same, there is no incentive for the company to redeem the bonds and the embedded call option will expire unexercised.
• These bonds typically offer lower interest rates compared to callable alternatives, reflecting their reduced risk profile.
• But these benefits aren’t without their tradeoffs, so it’s important to carefully consider your investment options and fully understand what you’re getting into.
• This discourages issuers from calling bonds unless the financial benefits outweigh the cost of the make-whole payment.

Callable Bonds Explained

When a borrower issues bonds, it generally makes interest payments to the investor throughout the life of the bond and repays the full face value of the bond on its maturity date. But in the case of callable bonds, an issuer has the right to redeem the bond (repay the principal) prior to the maturity date. When this happens, the borrower is no longer required to make interest payments to investors after the call date. Optional redemption callable bonds give issuers the option to redeem the bonds early, but often this callable bond meaning option only becomes available after a certain date.

Features

The investors of callable bonds enjoy higher income than any other bonds as they receive compensation either has a higher coupon rate or redemption at a premium. A callable bond is a type of fixed-income debt instrument with a call option. With the call option, the issuing entity gets the right to redeem the bond before its maturity date. However, the issuer is not under any obligation to redeem it before expiry. The certificate clears the bond’s terms and conditions at the time of issuance, including its maturity period, interest rates, redemption options, etc. Optional redemption bonds grant issuers the most flexibility, allowing them to call bonds at their discretion after the protection period expires.

• Often, the call protection period is set at half of the bond’s entire term but can also be earlier.
• That’s great news for the issuer, because it means it costs them less to borrow, but it might not be great news for you.
• Since issuers can redeem them at any time, investors demand a higher yield compared to non-callable bonds to compensate for the added risk.
• If interest rates fall to say 5% after five years, the bank would likely exercise the call option since the bank could refinance at a lower rate.

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Investors who hold callable bonds face reinvestment risk, which is the risk that they will not be able to reinvest their principal at the same rate of return if the bond is called early. This is especially important for investors who rely on the bond’s cash flows to meet their income needs. Callable bonds can be redeemed by the issuer before the maturity date, usually at a premium to the bond’s face value.

Should you invest in bonds?

On the other hand, if interest rates fall, the bonds will likely be called and they can only invest at the lower rate. This is comparable to selling (writing) an option — the option writer gets a premium up front, but has a downside if the option is exercised. The call price is the price at which the bond is redeemed if it is called early. This price is usually set at a premium to the bond’s face value, and it is designed to compensate investors for the loss of future interest payments. A callable bond is a debt instrument where the issuer has the right to return the investor’s principal and stop interest payments before maturity.

For example, a bond callable at a price of 102 brings the investor $1,020 for each $1,000 in face value, yet stipulations state the price goes down to 101 after a year. These bonds include provisions for early redemption under specific circumstances, such as regulatory changes or the destruction of assets securing the bonds. While less common than other types, extraordinary redemption bonds protect issuers from unforeseen events that could impact their ability to service the debt. This YTM measure is more suitable for analyzing the non-callable bonds as it does not include the impact of call features. So the two additional measures that may provide a more accurate version of bonds are Yield to Call and Yield to worst. Yields, or the interest rate a bond pays, and bond prices tend to have an inverse relationship, meaning they move in opposite directions.

Frequently Asked Questions About Callable Bonds

The issuer can redeem it any time after the protection period is over, making it a flexible option for financing. Thus, they can end their obligation of debt repayment within a limited time, which reduces the pressure in the finances on the business. On November 1, 2016, a company issued a 10% callable bond with a maturity of 5 years. If the company exercises the call option before maturity, it must pay 106% of face value.

The advantages of make-whole calls are most apparent once interest rates fall. Suppose an investor bought a bond at par value and interest rates declined from 10% to 5% after the investor held a 20-year bond for 10 years. If the investor receives only the principal back, the investor will have to reinvest at the lower 5% rate. Here, the make-whole call provision’s NPV compensates the investor for reinvesting at a lower rate. Callable bonds offer issuers flexibility but introduce risk for investors. The choice between them depends on an investor’s goals and risk tolerance.