A callable bond also called a redeemable bond, can be called by the issuer before the maturity date. Most bonds issued are callable bonds by default. However, callable bonds come with an embedded call feature that investors are aware of.
Bond issuers issue callable bonds in a high-interest rate market and expect to lower interest rates in the future. For this perceived risk, investors demand a higher coupon rate than other bonds. Callable bonds offer some benefits to issuers and investors, though.
Callable Bond – Definition
A callable or redeemable bond is a type of bond where the issuer can redeem or pay off the bond before its maturity date. The call option comes embedded with the bond features.
When the issuer calls a bond, it usually pays a premium on the bond’s face value to the investors. At this point, the issuers would pay accrued interest and would stop making coupon payments to the investors. Thus, the call feature of such bonds comes as an option and not an obligation to the bond issuers.
How Does a Callable Bond Work?
A callable bond can be redeemed by the issuers at any time before its maturity date. The issuers would call the bond if interest rates go lower than the existing bond rate. Thus, investors are prone to a reinvestment risk with a callable bond.
Bond issuers issue bonds to satisfy their capital needs for projects, expansions, or debt repayments. A call feature is an embedded option that provides further flexibility to the issuers. Callable bonds are issued in a high-interest rate environment where issuers hope for a decline in the interest rates in the future.
Working Example
Suppose a company issues a callable bond to raise $ 1 million with a face value of $100 if it offers a 7% interest rate to investors when the market interest rate is 6%. The bond comes with an embedded call feature after 4 years and a maturity period of 10 years.
If interest rates fall to 5% after 4 years, the issuers would call the bond and issue a new one at a lower interest rate. The issuers may pay a premium on the face value to compensate the investors. For instance, the issuer pays $102 to investors by exercising the call option.
This way, the issuer would still save on interest rate for the remaining 6 years even after repaying $ 1.2 million to the investors.
Annual interest for 6 years = (1,000,000 × 7%) × 6 = $ 420,000
Premium paid = $ 200,000, total Cost = $ 620,000
New annual interest for 6 years = (1,000,000 × 4%) × 6 = $ 240,000
Interest rate savings = $ 180,000. No premium required as there will be no redemption with lower interest rate.
Special Considerations with a Callable Bond
Although the call feature provides flexibility to the issuers, it comes with some restrictions. For example, issuers would add the clause for a call option that can be exercised only after a specified period, say, after 3 years from the issue date.
Bond issuers would also need to make a premium on face value to compensate the investors. In addition, as investors consider a redeemable bond a risky investment, they demand higher coupon rates. Thus, issuers must carefully analyze the costs of issuing a callable bond.
Types of Redemptions
The redemption clause can take three different forms from the bond issuers.
Extraordinary Redemption
It allows the issuer to call the bond if any extraordinary event takes place. For instance, if a sharp decline in interest rates or the project is suspended for which bond was initially issued.
Optional Redemption
Issuers can add an embedded option to redeem bonds after a specific period. For instance, a call option after 3 years of issuing date.
Sinking Fund Redemption
Issuers can set up a sinking fund that allows them to redeem the bond in a fixed proportion over time.
Advantages of a Callable Bond
A callable bond offers several advantages to the issuers and investors.
- Investors receive higher coupon payments with callable bonds as compared to other bonds.
- Issuers can raise capital with the flexibility of redemption at any time.
- The call feature allows issuers to take advantage of low-interest rates when available.
Disadvantages of a Callable Bond
Callable bonds also offer some disadvantages to both parties.
- Issuers would need to pay higher coupon payments to investors, raising the cost of capital.
- Investors cannot take advantage of higher interest rates, as issuers would not redeem in such a situation.
- Investors face a reinvestment risk as issuers can redeem the bond, and investors need to invest in a low-interest rate asset.
Final Thoughts
Callable bonds provide several benefits to issuers and investors. Investors would receive higher coupon payments for reinvestment and interest rate factors. At the same time, issuers can call these bonds when they receive lower interest rates in the market.
