What is a Callable Bond?

A bond that can be redeemed by the issuer before the specified maturity date is reached is referred to as a callable bond, sometimes called a redeemable bond. A callable bond enables the issuing corporation to settle its debt before its due date. As market interest rates decline, a company may decide to call their bond, enabling them to re-borrow money at a more favorable rate.

Callable Bonds Explained

A bond containing an embedded call option is referred to as a callable bond.

Bonds can be issued by corporations to finance growth or to settle other debt. If they anticipate a decline in market interest rates, they can choose to make the bond callable, which would enable them to redeem it early and obtain additional funding at a reduced interest rate. The parameters of when the corporation may recall will be outlined in the bond's sale.

In a callable bond, the issuer has the right to stop making interest payments and returning the investor's principal before the bond's maturity.

A callable, redeemable bond is often called at a price that is somewhat higher than the debt's par value.

The call option on these bonds often has some limitations. For instance, the bonds might not be redeemable during a predetermined initial period of their existence. Additionally, certain bonds only permit bond redemption in the event of specific unusual circumstances.

Callable bonds therefore offer a more appealing interest rate or coupon rate thanks to their callability.

If interest rates are anticipated to decline, callable bonds can be advantageous to the bond issuers. The issuers may choose to redeem their bonds in this situation and issue new bonds with reduced coupon rates.

Conversely, callable bonds expose investors to greater risk. The investors would forfeit most future interest payments if the bonds were redeemed. The speculative feature of the bonds usually entails a premium to make up for the added risk to investors.

Example of Callable Bond

Consider a scenario of XYZ Corp. which issued bonds with a face value of $150 and a coupon rate of 7.5%, on a 5% current interest rate. The bond's maturity period is 10 years.

If the corporation decides to redeem the bonds from investors after the first half of the maturity period (five years in this case), it issue the bonds with an embedded call option. 

Afterwards, if interest rates decreases XYZ Corp. can call back the bonds and replace them with new bonds that have a significantly a lower coupon rate. In this case, investors receive the face value of the bond but forfeit any future coupon payments.

The embedded call option will terminate without being exercised if the interest rate rises or stays the same because there will be no motive for the corporation to redeem the bonds.

By using callable bonds, a corporation can reduce interest costs and avoid long-term financial issues in the event that economic or financial conditions deteriorate. That is, a corporation may issue new debt at a lower interest rate than the initial callable bond if market interest rates drop after the bond is floated.

By exercising the call feature on the earlier callable bond, the corporation utilizes the revenues from the lower-rate issue to settle the debt. As a result, the business repaid its debt by substituting newly-issued debt with a lower interest rate for the callable bonds that had a higher yield.

Perks of Callable Bonds

Investors receive a higher coupon or interest rate from callable bonds than from non-callable bonds. The company may call the note if the market interest rate drops below the rate being provided to the bondholders. The debt could then be refinanced at a cheaper interest rate. In most cases, using this flexibility is better for the company than taking a loan from the bank.

But not all aspects of a callable bond are advantageous. When interest rates decrease, the issuer will often call the bond. Due to this calling, the investor is at risk of having their investment replaced at a rate that will not generate the same amount of revenue. On the other hand, if market rates increase and the investor's funds.

In contrast, if an investor's money is invested in a product that pays a lesser return as market rates rise, they risk falling behind. Ultimately, companies need to raise their coupons to appeal to investors. 

Types of Callable Bonds

Bonds that are callable come in a wide variety. Redeeming bonds voluntarily allows the issuer to do so in accordance with the conditions set forth at the time of issuance. Not all bonds, meanwhile, are callable. Generally speaking, Treasury bonds and Treasury notes cannot be called, but there are a few exceptions.

Callable bonds include several municipal bonds and some corporate bonds. A call feature on a municipal bond can be used after a predetermined time, such ten years.

Sinking fund redemption necessitates that the issuer follow a predetermined timeline when redeeming all or a portion of its obligation. The Company shall pay Bondholders a part of the Bond on certain dates. A sinking fund enables the business to gradually save money and prevent a huge payment at maturity.

Extraordinary redemption allows the issuer to call its bonds prematurely in certain circumstances, such as when the financed endeavor it is backing is harmed or destroyed.

Call protection is the period during which the bond cannot be called. A bond's callability and the specifics of the call option, such as the window of time during which the bond may be called, must be made clear by the issuer.