Callable Bonds

Updated on May 9, 2024
Article byWallstreetmojo Team
Reviewed byDheeraj Vaidya, CFA, FRM

What Is A Callable Bond?

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

What Is A Callable Bond

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These type of bonds are fixed-income financial instruments that are suitable for investors who are looking for regular income with the least amount of risk. They act as a hedge against any fluctuations in the market, providing financial security to the investor. Issuers may offer interest higher than the market rate to attract investors because of the uncertainty investors face regarding whether it will continue till maturity.

Key Takeaways

  1. A callable bond is a fixed-rate instrument with the option for the issuing business to return the security’s face value at a predetermined price before the bond matures.
  2. In a callable bond, the issuing business can return the bond’s face value at a pre-determined price before the bond matures. Callable bonds have a set rate.
  3. Callable bonds are valued through Yield to Maturity, Yield to Worst, Yield to Call, and Current Yield.
  4. A puttable bond is a bond with a put option, giving the bondholder the right but not the duty to request the principal amount ahead of schedule.

Callable Bond Explained

A callable bond is essentially a financial instrument that provides fixed income to the investors till the time they are not called for redemption by the issuer. Such bonds provide the right to the issuer to call back the bond from the investor any time before maturity. The other attributes of the bonds remain the same as any other bond.

In the ever-changing landscape of the financial market, where people are looking for new avenues of investments to grow their money, such bonds provide a good option to investors who are looking for a safe and steady return with very less amount of risk. However, since they are callable, investors have the risk of their income coming to a halt in case the issuer wants to redeem it. For this reason, issuers often offer interest higher than the market rate to get more investment. The issuer of such bonds generally looks for market conditions where there is a chance of interest rates going down in the future. In such cases, after issue, if the rates fall, the company calls back the bonds and reissues them at lower market rates, ensuring a gain of the net amount.

Sometimes, the issuer also promises during callable bonds accounting that if redeemed, it will be done at a rate that is higher than the market interest rates, which again attracts investors. Due to this, such investors can earn higher returns compared to traditional bondholders. However, no matter how high the interest rate offered is, it is necessary for bond investors always to check the credit rating of companies or financial institutions that are offering such securities. They should have the liquidity to pay the regular interest to bondholders.

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’.

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Features

Let us study the features of a callable bonds accounting with the help of the below mentioned table.

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, these bonds have a higher interest rate (Coupon rate).
  • The premium for the option sold by the investor is incorporated in the bond by way of the higher interest rate.
  • The call option generally has multiple exercise rates.

Types

Some common classifications of such a bond are as follows:

  • European callable bonds– They are those bonds which can be called back by the issuer at some specific dates after the call protection period, which is the date till which the bond cannot be redeemed. The bond indenture specifies such options clearly for investor knowledge.
  • American callable bond – This is the bond in which the issuer can redeem it any time after the completion of the protection period, which can be a few year after its issue. No particular dates of redemption are specified.
  • Bermuda callable bond – They have the characteristics of both the above.
  • Make-whole bond – In this, the issuer can call the bond at any time but require paying the investors a premium amount as a compensation of the interest rates that the investors will not earn any more.

The offer document of the indenture of the bond will contain all kinds of terms and conditions related to it like the interest rates, price, protection period, etc, which the investor should go through carefully before investment.

Examples

Let us understand the concept with the help of some suitable examples.

Example #1

Company ‘A’ has issued a callable bond on October 1, 2016, with an interest of 10% p.a maturing on September 30, 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 DateCall 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 can call the bonds issued to investors before the maturity date of September 30, 2021.

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

Example #2

Another example of such a bond is a Senior Secured Callable Bond due 22 March 2018 have been issued and registered with Verdipapirsentralen (VPS).

Example #3

On November 1, 2016, a company issued a 10% callable bond with a maturity of 5 years. If the company exercises the call option before maturity, it must pay 106% of face value.

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

Advantages

Let us study the advantages of the concept in details.

If interest rates are falling, the callable bonds issuing company can call the bond and repay the debt by exercising the call option and refinance the debt at a lower interest rate. In this case, the company can save interest costs.

The issuer can redeem it any time after the protection period is over, making it a flexible option for financing. Thus, they can end their obligation of debt repayment within a limited time, which reduces the pressure in the finances on the business.

These bonds generally have higher interest rates to compensate for the risk of being called early due to falling interest rates and

They are generally called at a premium (i.e., higher than the par value). This is due to additional risk investors take.

The bond investors may get back Rs 107 rather than Rs 100 if the bond is called. This Rs 7 additional is given due to the investor’s risk if the company recalls bonds early in falling interest rates scenario.

Disadvantages

  • Before investing one has to balance return and risk. And callable bonds are too complex to deal with.
  • Generally, when interest rates fall, normal callable bonds pricing go up. But, in the case of callable bonds, then bond prices may fall. This kind of phenomenon is called ‘compression of price.’
  • One has to ensure that the callable bond offers a sufficient amount of reward (maybe in the form of a higher interest rate than a market or maybe a higher repayment premium) to cover the additional risks that the bond is offering.
  • In case they need to be redeemed due to fall in the interest rates, the existing investors need to switch to financial instruments or options for investment which are less lucrative and has low return.
  • It is not suitable for investors who wish to get more return on their inevstmenst and are ready to take the risk required for it.

Structuring Of Call Options

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

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

Timing of Call

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

There are different types in terms of timing

  • European option: Only a single call date before the bond’s maturity.
  • Bermudan option: There are multiple call dates before the bond’s maturity.
  • American Option: All dates before maturity are call dates.

Pricing of Call

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

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

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

The Decision Of Calling A Bond

The issuer decision to call is based on many factors like

  • Interest rate factors. The company may redeem the bonds with relatively high coupon rates during falling interest rates and replace them with newly issued bonds (commonly called refinancing in vanilla terms). In the case of rising interest rates, issuers have an incentive not to exercise calling bonds at an early date. This may lead to declining bond yields over a term of the 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.
    • If the company is thinking of converting debt into equity, it may issue share in favor of bonds or repay bonds and go for FPO
  • Other factors: There could be many triggers where a company may feel it is beneficial to call the bond.

Valuation

Generally, the yield is the measure for calculating the worth of a bond during callable bonds valuation in terms of anticipated or projected return. However, there are various measures in calculating the yield.

Yield to maturity:

YTM is the aggregate total return a bond gives if held until maturity. It is always expressed as an annual rate.

YTM is also called a book yield or redemption yield.

A 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}

Let us 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, the interest rate is 10%. The price paid to purchase the 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 a more accurate version of bonds are Yield to Call and Yield to worst.

Yield to call

Yield to call would be the bond’s yield if you were to buy the callable bond and hold the security until the call exercise date. A calculation is based on the interest rate, time till call date, the bond’s market price, 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. The bond matures in 3 years. This bond is callable in 2 years at 105% of par. In this case, to calculate the bond yield, Mr. A needs to assume that the bond matures in 2 years instead of 3 years. Hence, the call price should be considered at Rs 1050(Rs1000*105%) as principal at maturity.

Let us assume the price paid to buy the bond in the 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 bondholder. This is because when interest rates fall, the issuer chooses to call the bonds and refinance its debt at a lower rate leaving the investor to find a new place to invest.

So, in this case, during callable bonds valuation, this yield to worst, is very important for those who want to know 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 matures in 10 years, and yield to maturity(YTM) is 4 %. The bond has a call provision where the issuer can call bonds in five years. The yield calculated assuming that the bond matures on call date (YTC) is 3.2%. In this case, the yield to worst is 3.2%

Also, check out Bond Pricing

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

Putable Bonds

  • It is a bond with an embedded put option where the bondholder has a Right but not the obligation to demand the principal amount early. The put option can be exercisable on one or more dates.
  • In the case of the rising interest rate scenario, investors sell the bond back to the issuer and lend somewhere else at a higher rate.
  • It is opposite to the callable bond.
  • The price of the putable 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 putable bond are lesser than the yield on a straight bond.

Callable Bond Vs Non-Callable Bond

The differences between both the above financial instruments are based on features, risk and return. Let us study the differences between them.

  • For the former, the issuer can redeem the bond before the date of its maturity whereas for the latter there is no option to redeem or call the bond before its maturity.
  • The investors are not sure of the bond remaining till maturity is case of the former. So, unlike the latter, they need to bear the risk of losing interest rates as a regular income in case the issuer calls for it.
  • Due to the above risk, in case of the former, the investors usually get an interest rate that is higher than the market rates prevailing at that time, which compensates for the income loss. This is not the case for the latter.
  • The former allows the issuer the flexibility to reduce teir own debt levels and ease the pressure of repayment leading to cash ooutflow. This is not possible in case of the latter.

Thus, the above are some essential differences between the two financial and fixed investment avenues.

Frequently Asked Questions (FAQs)

What are callable and non-callable bonds?

The agreement for callable bonds also specifies a call date beyond which the issuer is prohibited from calling the bond. Non-callable bonds cannot be called until the bond’s maturity date.

Why would you buy a callable bond?

They provide a higher-than-average rate of return, at least until the bonds are called away. In contrast, callable bonds appeal to issuers because they enable firms to cut interest expenses if rates drop.

Can callable bonds ever be called?

A bond that the issuer can redeem at any point before maturity is referred to as an American callable bond, also known as a continuously callable bond. Bondholders who own American callable bonds face a considerable reinvestment risk.