Callable Bonds | Definition | Example | Valuations

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Callable Bonds | Definition | Example | Valuations – A callable bond is a bond with a fixed rate where issuing company has the right to repay the face value of the security at a pre agreed value prior to maturity of the bond. The above is an example of Senior Secured Callable Bond due 22 March 2018 have been issued and registered with Verdipapirsentralen (VPS),

In this article, we look at Callable Bonds in detail.

What is a Non-Callable Bond?

  • Non callable bond is a bond where the issuer cannot call the bond till the date of maturity. Most common example of a non callable bond is India 10 years government bond, US Treasury bonds
  • In this case issuer of the bond exposes himself to the interest rate risk because interest rate is locked till maturity. If the interest rates decline, the issuing company must continue to pay the higher rate of interest until maturity.
  • Interest rates in non callable bonds tend to be lower than the interest rates on the callable bonds
  • In this case the risk is lower to the investor as the interest rate is freezed for a specific period of time despite the market volatilities.

What is a Callable bond?


A callable bond is a bond with a fixed rate where issuing company has the right to repay the face value of the security at a pre agreed value prior to maturity of the bond. The issuer of bond is having no obligation to buy back the security, he only have a right option to call the bond before issue.

Callable bond = Straight/ Non callable bond + option

Please note that some of the callable bonds become non-callable after a specific period of time after they issued. This time is called ‘protection period’

Features of Callable Bonds


features-of-callable-bond

  • The issuer company has a right but not an obligation to redeem the bond before maturity.
  • The call price is usually more than the issue price (Par price).
  • The underlying security has a variable life
  • The call option may have multiple exercise rates.
  • Generally the callable bonds have a higher interest rate (Coupon rate) than a non-callable bond.
  • The premium for the option sold by the investor is incorporated in the bond by way of higher interest rate.
  • The call option generally has multiple exercise rates.

Features of Callable Bond – Example


Company “A” has issued a callable bond on 1st October 2016 with an interest of 10% p.a maturing in 30th September 2021 .The amount of issue is 100 Crores . The bond is callable subject to 30 days’ notice and the call provision is as follows.

Call Date Call price
1 year (30th September 2017) 105% of Face value
2 years (30th September 2018) 104% of Face value
3 years (30th September 2019) 103% of Face value
4 years (30th September 2020) 102% of Face value

In the above example, the company is having an option to call the bonds issued to investors before the maturity date of 30th September 2021.

If you see, the initial call premium is higher at 5% of face value of bond and it gradually reduced to 2% with respect to time.

Purpose of issuing a callable bond


In case interest rates are falling, then the callable bonds issuing company can call the bond and pre pay the debt by exercising call option and then they can refinance the debt at a lower interest rate. In this case company can save interest cost.

For example: On 1st November 2016 if a company issues a 10% callable bond with maturity of 5 years. If company exercises call option before maturity, then it has to pay 106% of face value.

In this case, if as on 31st November 2018 the interest rates fell to 8%, the company may call the bonds and repay them and take a debt at 8%, thereby saving 2%.

Should we buy a callable bond?


  • Before investing one has to balance return and risk. And callable bonds are too complex to deal with.
  • Generally when interest rates fall, normal bond prices go up. But, in case of callable bonds, the bond  prices may fall. This kind of phenomenon is called “compression of price”
  • Callable bonds generally have higher interest rates to compensate the risk of being called early due to falling interest rates and
  • Callable bond generally been called at a premium(i.e price higher than the par value) This is due to additional risk investor takes.
  • For Example: Bond investor may get back Rs 107 rather than Rs 100 if the bond is called. This Rs  7 additional is given due to risk that investor takes incase company recalls bond early in falling interest rates scenario
  • So, one has to ensure that the callable bond offers sufficient amount of reward (May be in the form of higher interest rate than market or may be higher repayment premium) to cover the additional risks that the bond is offering.

Structuring of Call Options


Before issuing the bond, one of the important and complicating factors is deciding the following two factors…

  1. Timing of call. I.e when to call
  2. Determination of the price of bond that is being called. How much to pay of bond is called before due date

Timing of Call

The date on which the callable bond may be first called is “first call date”. Bonds may be designed to continuously call over a specified period or may be called on a mile stone dates. A “deferred call” is where bond may not be called during first several years of issuance.

There are different types in terms of timing

  • European option: Only Single call date before maturity of bond
  • Bermudan option: There are multiple call dates before the maturity of bond
  • American Option: All dates before maturity are call dates.

Pricing of Call

Pricing of the bond generally depends on the provisions of bond structure. The following are the different kinds of pricing

  • Fixed regardless of the call date
  • Price fixed based on predetermined schedule

Learn more about Options – What are Options and Options Trading Strategy

The decision of calling a Bond


The issuer decision to call is based on many factors like

  • Interest rate factors. During falling interest rates, company may exercise the option of redeeming the bonds with relatively high coupon rates and replace them with newly issued bonds (This is commonly called refinancing in vanilla terms). In the case of rising interest rates situation, issuers have an incentive not to exercise calling bond at early date . This may led to decline in bonds yield over term of investment.
  • Financial factors: If the company has sufficient funds and wants to reduce debt , it may call the bonds back even though interest rates are stable or rising.
    • In case company is thinking of converting debt into equity, it may issue share in favour of bonds or repay bonds and go for FPO
  • Other factors: There could be many triggers where company may feel its beneficial to call the bond.

Valuing the Callable bonds


Generally yield is the measure for calculating the worth of a bond in terms of anticipated or projected return . There are various measures in calculating the yield.

  1. Current yield
  2. Yield to maturity
  3. Yield to call
  4. Yield to worst

Yield to maturity:

YTM is the aggregate total return a bond gives if it is holded till maturity. It is always expressed as an annual rate.

YTM is also called as book yield or redemption yield.

Simple method to calculate YTM is as follows

YTM formula = [(Coupon) + {(Maturity Value – Price paid for bond)/(no of years)}] / {(maturity value + price paid for bond)/2}

Lets take an example to understand this a better way

Face value/maturity value  of a bond is Rs 1000, No of years of maturity is 10 years, interest rate is 10%. Price paid to purchase bond is Rs 920

Numerator = 100+(1000-920)/10

Denominator = (1000+920)/2 = 960

YTM =108/960= 11.25%

This YTM measure is more suitable for analyzing the non callable bonds as it does not include the impact of call features.  So the two additional measures that may provide more accurate version of bonds is Yield to call and Yield to worst.

Yield to call

Yield to call is the yield that the bond gives is you were to buy the callable bond and hold the security till the call exercise date. Calculation is based on interest rate, time till call date , market price of the bond and call price. Yield to call is generally calculated by assuming that the bond is calculated at the earliest possible date.

For example, Mr. A owns a bond of GOOGLE company with a face value of Rs. 1000 at a 5% zero coupon rate. Bond matures in 3 years. This bond is callable in 2 years at 105% of par.

In this case to calculate the yield of the bond, Mr.A need to assume that bond mature in 2 years instead of 3 years. Call price should be considered at Rs 1050(Rs1000*105%) as principal at maturity.

Let us assume price paid to buy bond in secondary market is Rs 980, then yield to call will be as follows

{Coupon + (call value- price)/time of bond} / {(Face value + price)/2}

Coupon payment is Rs 50 (i.e Rs 1000*5%)

Call value if Rs 1050

Price paid to acquire bond value is Rs 920

Time of bond is 2 years (Assuming call happens in 2 years)

Market price is Rs 980

YTC =  [50+(1050-920)/2]      (1000+920)/2

= 50+65/960   =12%                       

Yield to worst

Yield to worst is the lowest yield an investor expects while investing in a callable bond. Generally callable bonds are good for the issuer and bad for the bond holder because when interest rates falls, issuer choose to call the bonds and refinance its debt at a lower rate leaving the investor to find new place to invest.

Soo, in this case Yield to worst is very important who want to know what is the minimum they can get from their bond instruments.

Please note that ‘Yield to worst’ is always lower than ‘Yield to maturity’

For example:  A bond is maturing in 10 years and Yield to maturity(ytm) is 4% . The bond has a call provision where issuer can call bond in five years . The yield calculated assuming that the bond is maturing on call date (YTC) is 3.2%. In this case, Yield to worst is 3.2%

Also, checkout Bond Pricing

Now let us look at the Opposite of Callable Bond – Puttable Bond

Puttable bonds – Opposite of Callable Bond


  • It is a bond where there is an embedded put option where the bond holder has a Right but not the obligation to demand the principal amount at an early date. The put option can be exercisable at one or more dates.
  • In case of rising interest rate scenario , investors sells the bond back to the issuer and lends some where else at a higher rate.
  • It is opposite to the callable bond.
  • The price of the puttable bond is always higher than the straight bond as there is a put option which is an added advantage to the investor.
  • However the yields on the puttable bond is lesser than the yield on a straight bond.

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