Bonds are Fixed income security that pays income to the investor in the form of interest and principal at maturity. One such kind of bond is a Callable Bond. Callable bonds are bonds with embedded options wherein the issuer has the right to repurchase the bond back from the bondholder at a per specified price as stated in the bond indenture before the maturity of the bond. The bonds are not brought and held by the issuer they are canceled out immediately.
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A callable bond is a type of bond that gives the bond issuer the right, but not the obligation, to redeem the bond before its maturity date. It is a bond with an embedded call option. Callable bonds are also called redeemable bonds. A bond is redeemable if, prior to its maturity date, the issuer returns the investor’s principal and ends further payments of the interest. The issuer generally issues such bonds if it believes that the interest rate in the market will reduce so he can take advantage and reissue the bond at a lower rate of interest. If the rates have declined since the company or city initially issued the bond, the borrower will choose to refinance its debt at a lower interest rate. The issuer can then reissue their current bonds at a lower interest rate after calling them.
Some features of callable bonds are as under:
- Callable bonds are generally repurchased at a price exceeding the par or face value of the bond i.e. at a premium.
- They compensate investors as they typically offer a more attractive interest rate or coupon rate due to their callable nature.
- Callable bonds are riskier than non-callable bonds as they are called away by the issuer before the maturity date and the high-interest income paid to the investor will cease and the investor will have to invest the principal at a low interest in the market.
- The price of a callable bond is the present value of accrued interest and face value on the bond.
- Callable bonds price therefore don’t increase more than the price specified by the company.
Callable bonds have negative convexity. Convexity can be explained as when the interest rate increases, the price of the bond will decrease, and when the interest rate decreases the price of the bond will increase. Negative convexity is when the interest rate decreases but the price decreases. Because when the interest rate reduces the bond can be called anytime and hence callable bonds exhibit negative convexity.
How do Callable Bonds Work?
A callable bond basically acts like a plain vanilla bond. However, an investor is unsure as to whether it will continue to earn interest until maturity. The issuer is entitled to exercise the call option, rather than an obligation, they may not be able to redeem the securities before the redemption date. Let us take a look at the scenario below for a better understanding of the Callable Bonds.
XYZ Co. issues bonds with a $1000 face value and a 7 % coupon rate. The prevailing rate of interest is 5% and the bonds will mature in 10 years. However, the company issues the bonds with an embedded call option to redeem the bonds from investors for the first five years. If interest rates fall after five years, XYZ Co. will withdraw its bonds and refinance its debt with lower coupon rates. In this scenario, the face value of the bond is paid to holders, but potential payments for their coupons are forfeited. However, in the event that the interest rate increases or remains unchanged, there is no incentive for the corporation to repay the bonds.
Types of callable bonds:
- Optional Redemption: The company may redeem the bond according to defined terms at the time of issuance by means of an optional redemption.
- Sinking Fund Redemption: This requires the bond issuer to redeem a fixed proportion or more of the bonds on a periodic basis in compliance with the set schedule.
- Extraordinary Redemption: Enables a corporation to call a bond until it hits maturity when certain specific incidents happen.
Pros of a Callable Bond:
- Callable bonds pay a higher coupon than many of the fixed-income securities.
- For the issuing entity, it is more versatile as they can utilize their call option at any time outside the call protection timeframe.
- It allows the organization to raise funds to expand or repay its debts.
Cons of a Callable Bond:
- Investors are required to switch their bonds with low-yield, costly bonds. They do not benefit from the surge of higher interest rates.
- The high coupon rate may be expensive for the bond issuer.
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Author: Divya Sankhla
Divya has completed her graduation in Bachelors of Accounting and Finance. She has worked in Deloitte Touche Tohmatsu Services, Inc. as a Research Analyst for 1 year and at JM financial as a Credit Risk Analyst for 1.3 years. She is keen on learning about Financial Market. Well versed with Bloomberg, Capital Line, and Excel.