Callable Bonds

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.

You are free to use this image o your website, templates, etc, Please provide us with an attribution linkHow to Provide Attribution?Article Link to be Hyperlinked
For eg:
Source: Callable Bonds (wallstreetmojo.com)

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.

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’.

Features

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

• 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.

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%.

Now you can Master Financial Modeling with Wallstreetmojo’s premium courses at special prices

Best Financial Modeling Courses by Wallstreetmojo

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 optionEuropean OptionA European option can be defined as a type of options contract (call or put option) that restricts its execution until the expiration date. In layman's terms, once an investor has purchased a European option, even if the underlying security's price moves in a favourable direction, the investor cannot take advantage by exercising the option early.read more: Only a single call date before the bond’s maturity.
• Bermudan option: There are multiple call dates before the bond’s maturity.
• American OptionAmerican OptionAn American option is a type of options contract (call or put) that can be exercised at any time at the holder's will of the opportunity before the expiration date. It allows the option holder to reap benefits from the security or stock at any time when the safety or supply is favorable. A European option is the exact opposite of an American option wherein the option holder cannot sell the option until the day of expiration, even when it is favorable. In addition, there is no geographical connection concerning the names since it only refers to the execution of the options trade.read more: 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 refinancingRefinancingRefinancing is defined as taking a new debt obligation in exchange for an ongoing debt obligation. In other words, it is merely an act of replacing an ongoing debt obligation with a further debt obligation concerning specific terms and conditions like interest rates tenure.read more 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 shareIssue ShareShares Issued refers to the number of shares distributed by a company to its shareholders, who range from the general public and insiders to institutional investors. They are recorded as owner's equity on the Company's balance sheet.read more 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.

• Current YieldCurrent YieldThe current yield formula essentially calculates the yield on a bond based on the market price instead of face value. The current yield of bond= Annual coupon payment/current market priceread more
• Yield to maturityYield To MaturityThe yield to maturity refers to the expected returns an investor anticipates after keeping the bond intact till the maturity date. In other words, a bond's returns are scheduled after making all the payments on time throughout the life of a bond. Unlike current yield, which measures the present value of the bond, the yield to maturity measures the value of the bond at the end of the term of a bond.read more
• Yield to call
• Yield to worst

Yield to maturity:

YTM is the aggregate total returnTotal ReturnThe term “Total Return” refers to the sum of the difference between the opening and closing value of all the assets over a particular period of time and the returns thereon. To put it simply, the changes in opening and closing values of assets plus the number of returns earned thereof is the Total Return of the entity over a period of time.read more  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 callYield To CallYield to call is the return on investment for a fixed income holder if the underlying security, such as a callable bond is held until the pre-determined call date rather than the maturity date.read more 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 priceCall PriceA call price (CP) is the amount an issuer pays the buyer to buyback, call, or redeem a callable security before it matures.read more. 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

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 PricingBond PricingThe bond pricing formula calculates the present value of the probable future cash flows, which include coupon payments and the par value, which is the redemption amount at maturity. The yield to maturity (YTM) refers to the rate of interest used to discount future cash flows.read more

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

Putable Bonds

• It is a bond with an embedded put optionPut OptionPut Option is a financial instrument that gives the buyer the right to sell the option anytime before the date of contract expiration at a pre-specified price called strike price. It protects the underlying asset from any downfall of the underlying asset anticipated.read more 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)

Recommended Articles

• Coupon BondCoupon BondCoupon bonds pay fixed interest at a predetermined frequency from the bond’s issue date to the bond’s maturity or transfer date. The holder of a coupon bond receives a periodic payment of the stipulated fixed interest rate.read more
• Coupon Rate of BondCoupon Rate Of BondThe coupon rate is the ROI (rate of interest) paid on the bond's face value by the bond's issuers. It determines the repayment amount made by GIS (guaranteed income security). Coupon Rate = Annualized Interest Payment / Par Value of Bond * 100%read more
• What are Bonds?
• Unsecured Loans Examples