Bond investors lend their money to entities or issuers for a certain period of time and in return investors receive interest on the principal. These entities typically return the borrowed principle to the bond investors by the bond’s maturity date.
An exception to this process of bond investing is using callable bonds, which allows the issuer to pay off its loans early by buying back its bonds before they reach their date of maturity. You can define a callable bond as one with a built-in call option.
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What Is a Callable Bond?
Callable bonds, also referred to as redeemable bonds, allow the issuer the right, but not the obligation, to redeem the bond before it reaches its maturity date. The entity that issues callable bonds has the right to prepay, or in other words, the bond is callable before its maturity date.
Issuers may use callable bonds when they expect interest rates to fall. That way, they can redeem their bonds and issue new ones at a lower coupon rate, reducing their overall interest expenses.
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How Do Callable Bonds Work?
When the issuer calls the bond, it pays investors the call price or the face value of the bond, along with the accrued interest to date. After that, the issuer no longer has to make payments on the bond.
Businesses may prefer callable bonds, since they have built-in flexibility that could lower costs in the future. For example, if market rates are 5% when a company first issues its bonds but they drop to 2.5%, a bond issuer paying 5% would call their bonds and get new ones at 2.5%.
Some bonds have call protection which forbids the issuer to buy it back for a certain period of time. During this period, the company can not call their bonds. However, at the end of this period, the issuer can redeem the bond at its specified call date.
Callable bond prices correlate to interest rates, since falling interest rates make callable bonds less valuable.
Finding the Value of Callable Bonds
The main difference between a non-callable bond and a callable bond is that a callable bond has the call option feature. This feature impacts the calculation of the value of the bond. To find the value of callable bonds, take the bond’s coupon rate and add 1 to it.
For example, a callable bond with a 7% coupon would be 1.07. Next, raise 1.07 to the number of years until the bond is callable. If the bond is callable in two years, you would raise 1.07 to the power of two, which would be 1.1449. Then, multiply that number by the bond’s par value or face value.
If the bond’s par value is $10,000, you would multiply $10,000 by 1.1449 to get 11,449, which is the value of the callable bond.
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Pros and Cons of Callable Bonds
Like any other investment, callable bonds have benefits and risks. It’s important to keep in mind the pros and cons of investing in callable bonds when considering a long-term investing strategy.
Callable bonds are financial instruments that may carry more risk for investors than noncallable bonds (bonds only paid out at maturity) because there is the chance of the bond being called prior to it reaching maturity.
| Pros | Cons |
|---|---|
| Companies issue callable bonds at higher interest rates to compensate for the risk of early redemption. This means the possibility of greater investment returns. | If an issuer calls its bonds early as a result of lower interest rates, bond investors risk not being able to find bonds with lower coupon rates. This could pose a challenge for income-seeking investors who want a reliable stream of passive income from bond investing. |
| One of the benefits of callable bonds is the option to call the bond early. Instead of waiting until the bond reaches maturity, the issuer can recall the bond earlier to suit their financial business needs. | Callable bond investors who pay a premium, or more than a bond’s face value risk only getting back the face value of the bond. This means the investor would lose their money on the premium they already paid. |
| Callable bonds have benefits that mostly favor the issuer. When interest rates fall, the company can redeem the bonds early and issue new bonds at a lower rate to save on interest payments. | Another risk is the bond’s maturity. The longer it takes for the bond to mature, the greater the likelihood for the bond to be called early, especially if there is a change in interest rates. Investing in bonds with a shorter maturity date carries lower interest rate risk. |
Interest and Callable Bonds
From the perspective of the callable bond issuer, falling interest rates are an opportunity to recall your bonds and lower your interest rate. While the investor is compensated at the outset with a higher yield or coupon rate for investing in callable bonds, they must be aware of the added risks associated with this investment.
If interest rates stay the same or increase, there’s a lower chance the issuer will recall its bonds. But if investors believe interest rates will drop prior to the bond’s maturity date, they should be compensated for this additional risk. The investor must determine if the higher yield from callable bonds is worth the risk of investment because the call feature is an advantage to the issuer, not the investor.
Callable Bond Example
A callable bond with a par value of $1,000 and a 5% coupon rate issued on January 1, 2022 has a maturity date of January 1, 2030. The annual interest payments investors would receive is $50. This bond has a protection feature which doesn’t allow the issuer to recall the bond until January 1, 2026, but after that date, the bond can be redeemed.
The issuer believes interest rates will decrease within the next four years and decides to recall the bond on January 1, 2026. If the investor bought the callable bond through their broker at its $1,000 par value, and the issuer chooses to redeem it when the protection period expires in 2026, they would calculate the value of the callable bond as follows:
• Take the coupon rate and add 1 to it, to make 1.05.
• Next, multiply 1.05 to the fourth power since the issuer will hold on to it for four years.
• This calculation will yield 1.2155.
• Next, multiply 1.255 by the bond’s par value of $1,000 to get $1,215, the value of the callable bond.
Types of Callable Bonds
Bonds have different types of issuers. Municipalities and corporations both may issue callable bonds. Here’s a look at three common types of callable bonds.
1. Optional Redemption Callable Bonds
Some municipal bonds have a redeemable option 10 years after the issue of the bond was issued. However, bonds with higher yields might have a protection or waiting period according to the bond’s maturity date. For example, a five-year bond might not be able to be recalled until two years after it is issued.
2. Sinking Fund Redemption Callable Bonds
This requires the issuer to recall a certain amount or all of the bonds according to a fixed schedule. A sinking fund is money that a company reserves on the side to pay off a bond.
3. Extraordinary Redemption Callable Bonds
Extraordinary redemption is when the issuer recalls the bond before maturity if certain specified events in the bond contract occur such as a business scenario that impacts bond revenue.
Puttable Bonds
A puttable bond or a retractable bond allows the investor or bond holder the right but not the obligation to sell the bond back to the issuer before its maturity date at a specified time and price. This means a puttable bond has a put option or an option to sell a security at a certain price before its expiration date.
Puttable bonds are the opposite of callable bonds. While callable bonds benefit issues in a declining interest rate environment, potable bonds benefit the bond holder in a rising interest rate environment. If interest rates rise, the price of bonds will decrease in which case the bond holder can sell the bond back to the issuer and reinvest into a bond with a higher rate.
The Takeaway
Some investors might consider buying callable bonds as one way to diversify an investment portfolio or to achieve higher yield, however, it’s important for investors to keep the risks associated with this investment top of mind. In an environment where interest rates are falling, callable bonds may not work for long-term investors looking for income.
If you’re interested in building a portfolio without bonds, a great way to get started is by opening an investment account on the SoFi Invest® online brokerage. You can use it to buy stocks, exchange-traded funds, and cryptocurrency directly from the SoFi app on your phone.
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