how a callable bond works
a callable bond is a debt instrument in which the issuer reserves the right to return the investor s principal and stop interest payments before the bond s maturity date corporations may issue bonds to fund expansion or to pay off other loans if they expect market interest rates to fall they may issue the bond as callable allowing them to make an early redemption and secure other financings at a lowered rate the bond s offering will specify the terms of when the company may recall the note 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 for example a bond maturing in 2030 can be called in 2020 it may show a callable price of 102 this price means the investor receives 1 020 for each 1 000 in face value of their investment the bond may also stipulate that the early call price goes down to 101 after a year types of callable bondscallable bonds come with many variations optional redemption lets an issuer redeem its bonds according to the terms when the bond was issued however not all bonds are callable treasury bonds and treasury notes are non callable although there are a few exceptions most municipal bonds and some corporate bonds are callable a municipal bond has call features that may be exercised after a set period such as 10 years 1sinking fund redemption requires the issuer to adhere to a set schedule while redeeming a portion or all of its debt on specified dates the company will remit a portion of the bond to bondholders a sinking fund helps the company save money over time and avoid a large lump sum payment at maturity a sinking fund has bonds issued whereby some of them are callable for the company to pay off its debt early 1extraordinary redemption lets the issuer call its bonds before maturity if specific events occur such as if the underlying funded project is damaged or destroyed call protection refers to the period when the bond cannot be called the issuer must clarify whether a bond is callable and the exact terms of the call option including when the timeframe when the bond can be called callable bonds and interest ratesif market interest rates decline after a corporation floats a bond the company can issue new debt receiving a lower interest rate than the original callable bond the company uses the proceeds from the second lower rate issue to pay off the earlier callable bond by exercising the call feature as a result the company has refinanced its debt by paying off the higher yielding callable bonds with the newly issued debt at a lower interest rate paying down debt early by exercising callable bonds saves a company interest expense and prevents the company from being put in financial difficulties in the long term if economic or financial conditions worsen however the investor might not make out as well as the company when the bond is called for example let s say a 6 coupon bond is issued and is due to mature in five years an investor purchases 10 000 worth and receives coupon payments of 6 x 10 000 or 600 annually three years after issuance the interest rates fall to 4 and the issuer calls the bond the bondholder must turn in the bond to get back the principal and no further interest is paid in this scenario not only does the bondholder lose the remaining interest payments but it would be unlikely they will be able to match the original 6 coupon this situation is known as reinvestment risk the investor might choose to reinvest at a lower interest rate and lose potential income also if the investor wants to purchase another bond the new bond s price could be higher than the price of the original callable in other words the investor might pay a higher price for a lower yield as a result a callable bond may not be appropriate for investors seeking stable income and predictable returns advantages and disadvantages of callable bondscallable bonds typically pay a higher coupon or interest rate to investors than non callable bonds the companies that issue these products benefit as well should the market interest rate fall lower than the rate being paid to the bondholders the business may call the note they may then refinance the debt at a lower interest rate this flexibility is usually more favorable for the business than using bank based lending however not every aspect of a callable bond is favorable an issuer will usually call the bond when interest rates fall this calling leaves the investor exposed to replacing the investment at a rate that will not return the same level of income conversely when market rates rise the investor can fall behind when their funds are tied up in a product that pays a lower rate finally companies must offer a higher coupon to attract investors this higher coupon will increase the overall cost of taking on new projects or expansions pay a higher coupon or interest rateinvestor financed debt is more flexibility for the issuerhelps companies raise capitalcall features allow recall and refinancing of debtinvestors must replace called bonds with lower rate productsinvestors cannot take advantage when market rates risecoupon rates are higher raising the costs to the companyexample of a callable bondlet 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 the company pays its bondholders 6 x 10 million or 600 000 in interest payments annually three years from the date of issuance interest rates fall by 200 basis points bps to 4 prompting the company to redeem the bonds under the terms of the bond contract if the company calls the bonds it must pay the investors 102 premium to par therefore the company pays the bond investors 10 2 million which it borrows from the bank at a 4 interest rate it reissues the bond with a 4 coupon rate and a principal sum of 10 2 million reducing its annual interest payment to 4 x 10 2 million or 408 000 