What is a callable bond?

A Callable bond is a type of bond or debt security that allows the issuer of the bond to retain the privilege of redeeming it at some point before the date of maturity. It also comes with an embedded call option. In technical terms, callable bonds are cancelled immediately instead of being bought and held by the issuer. The call price for a callable bond will usually exceed its face value (par) or issue price. There may be a substantial amount of call premium associated with these bonds, especially in high-yield debt markets.

Bonds are generally issued by companies and governments to raise capital which is then redirected towards particular projects or expansion. The purchaser of the bond is required to pay the principal for the bond in exchange for the promise from the issuer/insurer that they will pay interest on the bond as well as pay back the principal amount when the bond reaches its time of maturity.

These bonds can be sold off during the bond term by the holder or to another investor at a higher or a premium price. This mostly occurs if the interest rate offered by the investor is higher than the newer issues. They may also be sold at a lower or discounted rate if the interest rates are not competitive.

Callable bonds refer to those bonds that may have their principal paid back by the insurer before the date of maturity of the bond. The insurer has the right to redeem the bond and pay back the principal amount but not the obligation to do so. If this predicament brings the issuer to a loss (a rise in interest rates) the issuer may choose to draw the bond out till its date of maturity instead of redeeming it beforehand.

Definition of a callable bond

A callable bond, also known as a redeemable bond, provides the issuer of the bond with the right to redeem it before its date of maturity but not with the obligation to do so. Usually, some restrictions are exercised on callable bonds regarding their call option. For example, the bonds may not be redeemable for a particular initial period of their lifespan. The bonds may also only be redeemable in the case of some extraordinary events.

Types of callable bonds

Callable bonds come in different shapes, sizes and variations; most of them with a redemption option that lets the issuer redeem the bond at a time stipulated and decided when issuing the bond. Callable bonds can prove to be extremely beneficial for the issuer, however not all bonds are callable. Treasury bonds and treasury notes are just a few examples of non-callable bonds.

Most bonds issued by companies and the government, corporate bonds and municipal bonds, are callable bonds. Municipal bonds usually come with a call feature to redeem the bond after a particular period, i.e. 10 years. Sinking fund redemption adheres to a different set of rules as compared to a regular callable bond. The issuer must adhere to a set schedule when redeeming a portion or all of its debt. A company will remit a portion of the bond to bondholders on specified dates.

A sinking fund refers to a fund created specifically to save money or set aside money to pay off a debt or a bond. A company may face an immense outlay when the time comes to pay off debts and bonds that it has issued in the past. In such a scenario, a sinking fund helps soften the blow of this large cost to be incurred. Out of the various bonds issued for a sinking fund, some of them are callable so that a company can pay off its debt early.

In the case of certain extraordinary events taking place or the underlying funded project or expansion plan being damaged, cancelled or destroyed, extraordinary redemption allows the issuer to call the bond before its date of maturity. Call protection refers to the period when the bond cannot be called. The issuer of the bond has to clarify the exact terms of the call option when it becomes callable (the time frame) and whether the bond is callable at all.

Callable bonds and interest rates

A callable bond gives a benefit to the issuer to take advantage of fluctuating market interest rates. Let’s say a company floats a callable bond and a few years after the fact, the interest rates in the market decline. The company can now opt to issue new debt at a lower interest rate than the original callable bond, the company will then use the proceeds from the new – lower-rate issue debt to pay off the first callable bond by exercising the call feature.

The final result of this is that the company has refinanced its debt by paying off the higher-yielding callable bonds with the newly issued, lower interest debt. In the same way, let’s say the interest rate didn’t decrease, it rather increased or even stayed stagnant. In this situation, the issuer will drag the bond out till the period of maturity as refinancing itself with new debt and using proceeds to avail the call option for the current bond would be a loss incurring for the business.

Paying a debt out early by exercising a callable bond is beneficial to the company as it saves the company interest-based expenses and also prevents the company from being put in worsened financial difficulties in the future if economic or financial conditions dwindle.

Example of a callable bond

Let’s say company Naidu Steels Ltd issued a bond with a face value of 80 crore rupees with a coupon rate of 5.5% and an interest rate of 3.5% where the bond will mature in 10 years. A call option is also associated with the bond where the bond can be redeemed from the investors after 5 years.

After 5 years, the interest rate has decreased to 2.75%. Naidu Steels Ltd may now decide to call back the bonds and refinance themselves with newly issued bonds in place of the current ones, using the funds acquired from the new issue to pay off the existing bonds. Therefore, they will benefit from the decreased interest rate whereas the investors will receive the face value of the bond in full but they will end up missing out on future coupon payments.

Let’s suppose the interest rate does not fall. But, in fact, it rises. Naidu steels in this scenario would not avail the option to redeem the bond after 5 years and may draw it out till the end of the bond maturity period unless the interest rate takes a dip between the 5 and 10-year mark.

Frequently Asked Questions

Is a callable bond good for investors?

A callable bond isn’t always a good option for investors as the issuer may redeem the bond before the bond’s maturity. In this situation, the investor receives both the face value of the bond as well as the coupon payments up till that point but the investor misses out on future and expected coupon payments.

Can callable bonds be converted to stock?

When a company exercises the right to redeem or call the convertible bond, it can force the conversion of convertible bonds to stocks.

What is the difference between callable and puttable bonds?

The primary difference between a puttable bond and a callable bond is that a puttable bond is purchased at a discount and has a higher yield rate than a coupon rate whereas callable bonds are purchased at a premium and will have a lower yield rate than the coupon rate.