What are Callable Bonds?
A callable bond is a type of bond that provides the issuer with a right but not an obligation to redeem the bond before its maturity date. This bond allows the issuing company to clear its debts early. The company may consider calling its bond early if the market interest rates tend to fall. Thus, this allows the companies to re-borrow at a more beneficial rate.
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Callable bonds are also known as redeemable bonds. These bonds become more favourable to companies when the interest rates fall. Also, it benefits the investors as it compensates them with attractive coupon rates or interest rates that prevail in the market. Or else, the issuer may promise redemption at a price higher than the face value of the bond.
How does a Callable Bond Work?
A callable bond is a debt instrument where the issuer has the right to return the investor’s principal and stop interest payments before maturity.
The companies issues these bonds to pay off other loans or fund expansion. Generally, companies issue these bonds when they expect that the market interest rates will fall. This allows them early redemption and secures the financing at a lower rate. The offer document will specify the terms when the company may recall the security.
The investors of callable bonds enjoy higher income than any other bonds as they receive compensation either has a higher coupon rate or redemption at a premium. The premium rate depends on the period left for the maturity of the bond. The earlier the issuer will redeem the bond, the higher is the premium.
A company ABC issues a callable bond of face value Rs.1000 with a maturity of 10 years. However, after five years, it decides to redeem the bonds at a premium of 2%. Therefore, the bondholder will receive Rs.1020 during redemption. However, the issuer may also stipulate a premium of 1% if they redeem after five years.
Types of Callable Bonds
The following are different types of callable bonds.
The issuer has the option to redeem these bonds as per their terms after a certain period. For example – a municipal bond has optional call features where the issuer can redeem it after a certain period, which is usually ten years.
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Sinking Fund Redemption
The issuer has to redeem a certain amount of the bond at fixed intervals per the set schedule. The company will remit a portion to the bondholders on these specified dates. Therefore, a sinking fund helps the company to save money and avoid sizeable lump sum payments at maturity,
The issuer can redeem these bonds early on the happening of a particular event. For example, the bond is issued for a specific purpose, like constructing a plant. However, the same is discontinued or damaged, the company can redeem the bonds.
How is a Callable Bond Valued?
The value of a callable bond differs from a common bond because of its call option feature. The call option negatively affects the price of the bond. This is because the investors may lose future coupon payments if the call option is exercised. The following is the formula to determine the value of a callable bond.
Price of a callable bond = Price of regular bond – Price of a call option
Price of regular bond: Price of a straight or plain-vanilla bond with similar features of a callable bond.
Price of call option: The price for redeeming the bond before maturity, which becomes an opportunity cost for investors.
Advantages and Disadvantages of Investing in a Callable Bond?
The following are the advantages of investing in a callable bond.
- Callable bonds pay higher interest rates than any other fixed instruments because the issuer has an option to call the bond anytime.
- This bond provides flexibility to issuers because of the embedded call option. Also, they can move to a lower interest rate bond when the interest rates are falling.
- It provides investors with fixed interest payments until the period the bond is held.
- This bond is more favourable for businesses for sourcing of funds.
The following are the disadvantages of investing in a callable bond.
- Investors are at a disadvantage when the bonds are redeemed. Thus, the investors may have to shift to a lower interest rate investment.
- The issuing company need to incur higher finance costs for servicing the callable bonds. However, it provides higher returns to the investors.
- The option to call the bonds rests with the issuer and not investors. Thus, investors have no advantage when the market interest rates increase.