Definition
Callable bonds are types of debt securities that issuers can repay before the bonds’ maturity date. The issuer, not the bondholder, holds this option, and there are specific terms and conditions for calling the bond. The call feature allows the issuer to take advantage of falling interest rates because the issuer can redeem the old, high-rate bonds and issue new, lower-rate bonds.
Key Takeaways
- Callable Bonds are types of bonds that provide the issuer the right, but not the obligation, to call back the bonds from the bondholders before they mature. This means the issuer can repay the principal before the maturity date, at the callable price.
- These types of bonds are beneficial for issuers in a declining interest rate environment, as they can pay off old bonds issued at higher interest rates with newly issued bonds at lower interest rates.
- While offering the potential of higher coupon payments, Callable Bonds also impose reinvestment risk on bondholders. If the bonds are called early, investors may need to reinvest their money at the prevailing lower interest rates.
Importance
Callable Bonds are a crucial instrument in the finance world due to their flexibility and the potential advantages they offer to issuers. Essentially, these are bonds that the issuer can redeem before they mature.
The option of retiring an outstanding bond issue at a predetermined call price adds a layer of security for the issuer. This feature is particularly important under falling interest rates scenario where issuers can buy back their existing higher-interest debt and reissue bonds at a lower interest rate, which can lead to substantial savings.
However, this potential benefit for issuers implies a corresponding risk for investors, as they face the risk of the bond being called away when interest rates drop. Understanding the dynamics of callable bonds can help both issuers and investors make informed decisions.
Explanation
Callable bonds are a unique type of financial instrument typically used by corporations or governments to mitigate the risks attached to changes in interest rates. The characteristic feature of a callable bond is its “call feature,” which provides the issuer—and not the holder— with the right to redeem the bond prior to its maturity date at the ‘call price’. It lets the issuing body restructure their debt, if the circumstances are favorable.
The primary purpose of opting for this type of bond is to take advantage of potential decreases in interest rates. In a falling interest rate environment, the issuer can recall the bonds, essentially paying off their existing high-interest debt and reissuing new bonds at a lower interest rate.
As a result, the issuer can significantly reduce their interest expense. Therefore, callable bonds are a strategic tool for entities to capitalize on favorable market conditions and protect themselves from overpaying interest.
Examples of Callable Bonds
Corporate Bonds: Often, corporations issue callable bonds when they predict that interest rates may decline in the future. For example, let’s say Corporation X issues a callable bond with a 10-year maturity period and an interest rate of 7%. If interest rates drop to 4% after 5 years, Corporation X might decide to call its bonds and issue new ones at the lower rate. This allows Corporation X to save on interest expenses.
Municipal Bonds: Many municipal bonds are callable. Municipals are generally issued by city, county, or state governments for public projects like roadways, bridges, or schools. For instance, in 2010, the city of Los Angeles issued callable bonds to finance the construction of a new bridge. The city reserved the right to repurchase these bonds from the holders if it could refinance at a lower interest rate in the future.
Mortgage-Backed Securities: These financial products are often callable. A typical example is a mortgage-backed security issued by Freddie Mac or Fannie Mae. These institutions buy mortgages from banks, bundle them into securities, and then sell those securities to investors. These securities often include a call provision, allowing Freddie Mac or Fannie Mae to buy back the bonds if interest rates decrease, or if they have reason to believe that the underlying mortgages will be paid off early.
Frequently Asked Questions About Callable Bonds
What is a Callable Bond?
A Callable Bond is a type of bond that allows the issuer the right to redeem the bond before its maturity date, under certain conditions. The specific details regarding when and how the issuer can call the bond is stated clearly in the terms of the bond contract.
Why would a company issue Callable Bonds?
A company may decide to issue Callable Bonds because they can potentially lower their debt costs. If interest rates decline after the issuance of the bond, the issuer can buy back the bonds in the market, retire them, and reissue new bonds at a lower interest rate.
What is the risk associated with Callable Bonds?
The major risk associated with Callable Bonds is called call risk. This happens when an issuer calls back the bonds due to a fall in interest rates. If a bond is called, investors will stop receiving interest payments and have to reinvest the returned principal, which might be at a lower interest rate especially in a declining interest rate environment.
How can we measure the yield of a Callable Bond?
Yield of Callable Bond is usually measured with yield to call (YTC) instead of yield to maturity (YTM). Yield to call takes into account both the income received from interest payments and the potential loss or gain in principal at the bond’s call date.
How to calculate the price of a Callable Bond?
The price of Callable Bonds can be calculated by discounting its expected cash flows by the current market interest rate. But the pricing may also take into account the optionality of the bond being called, which adds another layer of difficulty.
Related Entrepreneurship Terms
- Call Price
- Call Date
- Call Premium
- Call Protection
- Yield To Call
Sources for More Information
- Investopedia – A comprehensive data source with many references to finance-related terms, including Callable Bonds.
- Fidelity – A well-known financial services company; provides a wealth of knowledge on finance and bond-related concepts.
- Financial Times – A respectable international daily newspaper focusing on business and economic issues, including bonds market and its terminologies.
- Bloomberg – A leading global provider of financial market data and trading technologies; provides in-depth insights into finance terminologies, including Callable Bonds.
