What it is:
How it works (Example):
The bond indenture will stipulate when and how the bond can be called, and there are usually multiple call dates throughout the life of a callable bond. Many corporate and municipal securities have 10-year call provisions. For example, let's consider an XYZ bond issued in 2000 and maturing in 2020. The indenture might stipulate that XYZ Company may call the bond in the second, fourth, and tenth year.
The ev in the indenture also sets forth the call price, which is what the issuer must pay to redeem the bond. In our example, the indenture might say, The XYZ bond due June 1, 2020, is callable on June 1, 2004, at a price of 105% of par. (The indenture typically provides a table of call dates and prices as well.) Note that the call price is normally higher than the face value of the bond, but it decreases the closer the bond is to maturity. For example, XYZ Company is offering 105% of eci if it calls the bond after four years, but it may only offer 102% if it calls the bond in ten years, when it is closer to maturity.
The difference between the face value and the call price is called the call premium. In our example, the call premium is 5% in 2004. In many cases, the call premium is equal to one year's interest if the bond is called in the first year.
Intuitively, a callable bond is a traditional, non-callable bond, with a call option attached. Thus, the price of a callable bond can split into the price of the non-callable bond and the price of the call option. This is why options pricing models can be used to price callable bonds and to calculate their option-adjusted yields, durations, and convexities.
Why it Matters:
Call provisions considerably alter bond analysis because they add two dimensions of risk to bondholders. First, they present reinvestment risk. When interest rates fall, the bond issuer is more likely to exercise the call provision in order to retire what has become high-interest debt and reissue the debt at the prevailing lower rate. This leaves the investor with cash that must be reinvested in a lower interest rate environment.
Second, call provisions limit a bond's potential price appreciation because when interest rates fall, the price of a callable bond will not go any higher than its call price. Thus, the true yield of a callable bond at any given price is usually lower than its yield to maturity.
Because call provisions are less favorable to investors, bonds with call provisions tend to be worth less than similar non-callable bonds. However, if the investor receives enough compensation for the risks associated with call provisions, it shouldn't be a deterrent.