What is a Callable Bond?
How Does a Callable Bond Work?
A callable bond (also called a "redeemablecall option. If the issuer agrees to pay more than the face value amount of the when called, the excess of the payment over the face amount is the "call premium". In most cases, the call price is greater than the par (or issue) price.") is a with an embedded
To simplify the concept, let's look at an example:
Company ABC decides to borrow $10 million in themarket. The bond's coupon rate is 8%. Company analysts believe interest rates will go down during the 7 year term of the bonds. To take advantage of lower rates in the future, ABC issues callable bonds.
Under the terms of the bonds (the "indenture"), ABC has the option to call the bonds (meaning, pay them back) any time after year 3. However, if ABC decides to exercise its right to call, it needs to pay bondholders $102 for every $100 of principal.
Let's assume that in year 4, interest rates fall to 6%. ABC exercises its right to redeem the bonds. It borrows money from a bank at 6% and pays back the 8% bonds.
Even though ABC had to spend $10.2 million to pay back its current bondholders, it will benefit going forward because future interest payments will be only $612,000 per year ($10,200,000 * 6%) vs. $800,000 per year ($10,000,000*8%).
Why Does a Callable Bond Matter?
A callable bond is worth less to an investor than a noncallable bond because the company issuing the bond has the power to redeem it and deprive the bondholder of the additional interest payments he'd be entitled to if the bond was held to maturity.
[Click here to use our Yield to Call Calculator]
Typically, bonds are called when interest rates fall so dramatically, the issuer can save money by floating new bonds at lower rates. If by the time of the call date interest rates have significantly dropped, the issuer is motivated to call the bonds because doing so will allow it to refinance its debt at a cheaper level. From another perspective, the issuer is incentivized to buy bonds back at par value, because as interest rates go down, the price of the bonds goes up.
If interest rates drop, the bond's issuer will be strongly motivated to save money by replaying it callable bonds and issuing new ones at lower coupon rates. In these circumstances, the investor that holds the bonds will see his interest payments stop and obtain his principal early. If the investor then reinvests this principal in bonds again, chances are that he will be forced to accept a lower coupon rate that is in line with the prevailing (and lower) interest rates (called "interest rate risk").
Personalized Financial Plans for an Uncertain Market
In today’s uncertain market, investors are looking for answers to help them grow and protect their savings. So we partnered with Vanguard Advisers -- one of the most trusted names in finance -- to offer you a financial plan built to withstand a variety of market and economic conditions. A Vanguard advisor will craft your customized plan and then manage your savings, giving you more confidence to help you meet your goals. Click here to get started.