A callable bond, which is also referred to as a redeemable bond, is a type of investment that gives issuers the ability to pay off their debt ahead of the bond’s maturity date. Companies might decide to call these bonds when interest rates decrease, allowing them to borrow again at better rates. Because of this flexibility, callable bonds typically provide higher interest rates to investors than non-callable bonds.
Learn more about Callable Bond
A callable bond is a type of debt instrument where the issuer has the option to return the investor’s principal and halt interest payments before the bond reaches its maturity date. Companies might issue these bonds to finance their growth or to pay off existing loans. If they anticipate a drop in market interest rates, they could opt for a callable bond, which allows them to redeem it early and secure new financing at a lower rate. The bond’s offering will outline the conditions under which the company can recall the note.
A callable—redeemable—bond is usually called at a price that is a bit higher than the par value of the debt. The sooner a bond is called during its lifespan, the greater its call value will be. For instance, a bond set to mature in 2030 could be called as early as 2020, potentially showing a callable price of 102. This means the investor would receive $1,020 for every $1,000 of face value in their investment. Additionally, the bond might specify that the early call price decreases to 101 after one year.
Some Types of Callable Bond
Callable bonds come in various forms. Optional redemption allows an issuer to redeem its bonds based on the terms set at the time of issuance. However, not every bond is callable. Treasury bonds and Treasury notes are non-callable, though there are a few exceptions.
Most municipal bonds and some corporate bonds are callable. A municipal bond typically has call features that can be exercised after a certain period, like 10 years.
Sinking fund redemption requires the issuer to follow a specific schedule for redeeming part or all of its debt. On designated dates, the company will pay back a portion of the bond to bondholders. This sinking fund approach helps the company save money over time and prevents a hefty lump-sum payment at maturity. In a sinking fund, some bonds are callable, allowing the company to pay off its debt early.
Extraordinary redemption permits the issuer to call its bonds before maturity if certain events happen, such as damage or destruction of the project that was funded.
Call protection is the timeframe during which the bond cannot be called. The issuer needs to specify whether a bond is callable and detail the exact terms of the call option, including the timeframe in which the bond can be called.
The Example
Imagine Apple Inc. (AAPL) decides to take out a loan of $10 million in the bond market by issuing a bond with a 6% coupon rate that matures in five years. Each year, the company pays its bondholders 6% of $10 million, which amounts to $600,000 in interest payments.
Fast forward three years after the bond was issued, and interest rates drop by 200 basis points (bps) to 4%. This change leads the company to redeem the bonds. If Apple calls the bonds, it has to pay investors a premium of $102 for each bond. So, the total payment to bond investors comes to $10.2 million, which the company borrows from the bank at a 4% interest rate. Then, it reissues the bond with a 4% coupon rate and a principal amount of $10.2 million, which lowers its annual interest payment to 4% of $10.2 million, totaling $408,000.
Conclusion
Callable bonds give issuers the option to pay off their debt sooner if interest rates fall, which can help lower interest costs. On the flip side, investors might deal with reinvestment risk since they could have to look for new investments at lower rates. Even though these bonds offer higher interest rates to attract investors, they also increase expenses for issuers. Knowing the pros and cons of callable bonds can help make smarter choices in investing and borrowing.