A callable bond is a bond that can be redeemed by the issuer prior to its maturity. If interest rates have declined since the company first issued the bond, the company is likely to want to refinance this debt at the lower rate of interest.
In this case, the company "calls" its current bonds and reissues them at a lower interest rate. A bond is a debt instrument in which investors earn interest on the par value of the bond. The issuer makes periodic interest payments to bondholders for the duration of the bond.
Upon maturity, the principal investment is repaid to the investor. However, bonds that have a call feature may not reach their maturity dates. A callable bond means the issuer reserves the right to return the investor's principal and stop interest payments before the bond's maturity date.
For example, a bond maturing in can be called in A callable, or redeemable, bond is typically called at an amount slightly above par value; the earlier a bond is called, the higher its call value. Most municipal bonds and some corporate bonds are callable.
Treasury bonds and notes , with very few exceptions, are non-callable. A callable bond pays an investor a higher coupon than a non-callable bond. The issuer has flexibility in payment amount and loan length when borrowing money from an investor. Issuing a bond lets a corporation borrow at a lower interest rate than a bank loan, saving the company money. Bonds are usually called when interest rates fall. This exposes the investor to reinvestment risk , which involves reinvesting the principal at a lower interest rate.
The bondholder must turn in the bond to get back the principal and no further interest is paid. The investor might choose to reinvest at a lower interest rate and lose potential income. To reduce its cost of borrowing, when interest rates rise, the issuer will call its bonds from the market and have them reissued at the lower interest rate. When a company reissues a bond at a lower interest rate, the bond costs the investor more than when it was originally issued. The company can call a bond at a price below the market price.
The price of a callable bond will not be much higher than its call price , as lowering interest rates mean calling the bond is likely. An investor must consider the yield-to-call YTC and yield-to-maturity YTM when analyzing potential returns for a callable bond to ensure the potential income matches his objectives.
A callable bond may not be appropriate for an investor seeking regular income and predictable returns. Optional redemption lets an issuer redeem its bonds when it chooses. For example, a municipal bond has call features that may be exercised after a set time period, typically 10 years.
Sinking fund redemption requires the issuer to adhere to a set schedule while redeeming a portion or all of its bonds. Extraordinary redemption lets the issuer call its bonds before maturity if specific events occur, such as if the underlying funded project is damaged or destroyed. Call protection means a set time where the bond cannot be called. The issuer must clarify whether a bond is callable and the exact terms of the call option, including when it can be redeemed and what the price will be when the bond is first sold.
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