Updated July 13, 2023
What are Callable Bonds?
Callable bonds are debt instruments redeemable at the issuer’s option. Therefore, the issuer can redeem this bond before maturity and pay off their debt.
These are redeemable bonds that the issuer can redeem at their own will before maturity. Usually, an issuer can redeem it earlier if the interest rate in the market reduces where they can redeem the bond and pay off their debt. They can borrow again from the market at a lower interest rate. Therefore, investors prefer callable bonds as they get more attractive returns than the usual ones, as the issuer can redeem them early.
How Does it Work?
Callable bonds are issues with an option at the hands of the issuer to redeem them earlier than the maturity period. If the issuer expects that the interest rate may fall in the future, then they prefer to issue callable bonds as they can redeem the bonds and obtain funds at a much lower rate when the interest rate falls. While redeeming the callable bonds at a higher price than the par value, as they call it earlier. The call price will be higher if the issuer redeems the bonds early and vice versa. In other words, calling the bonds earlier in the bond tenure will result in a higher call price.
Examples of Callable Bonds
ABC Corp issued callable bonds for $5 Million with a 5% coupon rate for a period of 5 years maturing in 2025 with a par value of $100 per bond. The interest cost per annum comes to $250,000. After 2 years of issue, the interest rate in the market fell by 2% (200 basis points); now, the debt can obtain at 3%. If the same funds borrow from the outside market, the interest will cost $150,000. The company could save $300,000 (3 yrs * $100,000 savings per annum due to revised interest rates)
Considering the present scenario, they have planned to redeem it earlier as interest rates in the market have reduced. To redeem the bonds, they plan to do it at the callable price of 102. (i.e.) If the par value of a per bond is $100, they plan to redeem it at $102, where the investor in the bond gets $2 additionally for each bond considering the early redemption. The additional cost is $100,000 ($2 * 50000 bonds). -So the net savings for ABC Corp is $200,000 ($300,000 -$100,000).
Types of Callable Bonds
Below are the different types of Callable Bonds:
- Optional redemption: The issuer can redeem the bonds at their will after a certain period. E.g., Municipal bonds have the optional call feature where they can redeem after a certain period at the issuer’s option, usually 10 years.
- Sinking Fund redemption: In this issuer has to redeem a certain amount of bond at fixed intervals by a predefined schedule.
- Extraordinary redemption: In this issuer can redeem the bonds early on happening of certain extraordinary events. (E.g.)If a remarkable event causes the discontinuation of the construction of a plant for which the bond is issued, then the issuer can call the bond.
Values
The value of callable bonds differs from regular bonds as they have an additional option to call the bonds early. The call option affects the bond price as the investors may lose interest income if the bonds are called. The following is the formula for callable bonds.
Where,
- Price of regular bond: Price of the Straight bond (Plain vanilla bond) that pays interest to the investors at fixed intervals, and the principal is repaid on maturity.
- Price of Call option: The price considered for availing the benefit of redeeming (Call option) the bond before maturity. It is the opportunity cost for the investors.
Callable Bonds Risk
In this case, both issuer and investors may encounter certain risks. In the case of the issuer, the coupon or interest rates can be a little higher in the case of callable bonds, and also, if they call it early, they will pay a price higher than the par value. Callable bonds are favorable only when the interest rates reduce in the future. The issuer can call the bonds if the interest rate increase in the future, then the issuer ends up paying higher interest to the investor than the non-callable bonds, and also, they don’t enjoy any benefits since they won’t call the bonds considering the higher interest rate in the market.
In the case of investors, if the bonds are called, the investor may lose the interest income, and when they reinvest, they may fetch only lower interest rates, leading to lower interest income. Moreover, the reinvestment risk also applies concerning the new bond’s price, where the bond price could be trading higher than the original callable bonds, and they may get lower income from a high investment. Therefore, it may not be suitable for investors who need stable and secured income.
Why are Callable Bonds Issued?
Callable bonds are issued by corporates considering the flexibility it provides to the issuers. They can call the bonds anytime they want during the bond tenure by paying the price higher than the par value. This is chosen predominantly in the economy where the interest rates are volatile, and it is expected to reduce in the future.
With the help of callable bonds, corporates can refinance their debt from the market with a lower interest rate and pay off the investors. This could help the company save on the interest cost; otherwise, they would pay higher interest to the investors when funds are available at lower rates in the market.
Benefits
- Callable bonds pay higher interest to the investors as the issuer can call the bond anytime they want.
- This debt instrument is more flexible to the issuer as they can call the bonds anytime, and also they can move to any lower interest rate instrument when the interest rate falls in the market.
- It is one of the easier ways to source funds for the business.
Disadvantages
- Investors will be disadvantaged once the bonds are called back; the investors may have to move to low-interest investments.
- There is no advantage for investors when the interest rate in the market increases, as the option to call the bonds is only with the issuer and not with investors.
- Considering the flexibility, it pays higher returns than non-callable bonds; it adds up to higher finance costs for the company.
Conclusion
Callable bonds are preferred in an economy where the interest rates are volatile and are expected to fall. It gives the issuer an option to call the bonds before maturity, and to compensate for this; investors are paid a little higher interest than the market rate. Both issuers and investors carry certain risks, and the investment plan has to be decided based on the needs and expectations.
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