What are Callable Bonds?
Callable bonds are a debt instrument that is redeemable at the option of the issuer. Therefore, the issuer can redeem this bond before the maturity period and pay off their debt.
Callable bonds are redeemable bonds that the issuer can redeem at their own will before the maturity period. Usually, an issuer of callable bonds redeems it earlier if the interest rate in the market reduces where they can redeem the bond and pay off their debt, and they can borrow again from the market at a lower interest rate. Therefore, investors prefer callable bonds as they get more attractive returns than the usual bonds as the issuer has the option to redeem them early.
How does it work?
Callable bonds are issued with an option at the hands of the issuer to redeem them earlier than the maturity period. If the issuer expects that the interest rate may fall in the future, then they prefer to issue callable bonds as they can redeem the bonds and obtain funds at a much lower rate when the interest rate falls. While redeeming the callable bonds, it is done at a price higher than the par value, as they call it earlier. Therefore, the call price will be higher if bonds are redeemed early and vice versa (i.e.), if the bonds are called earlier in the bond tenure higher, will the call price.
Examples of Callable Bonds
ABC Corp issued callable bonds for $5 Million with a 5% coupon rate for a period of 5 years maturing at 2025 with a par value of $100 per bond. The interest cost per annum comes to $250,000. After 2 years of issue, the interest rate in the market falls by 2% (200 basis points); now, the debt can be obtained at 3% in the market. If the same funds are borrowed at the outside market, the interest cost would be $150,000. The company could save $300,000 (3 yrs * $100,000 savings per annum due to revised interest rates)
Considering the present scenario, they have planned to redeem it earlier as interest rates in the market have reduced. To redeem the bonds, they are planning to do it at the callable price of 102. (i.e.) If the par value of a per bond is $100, they are planning to redeem it at $102, where the investor in bond gets $2 additionally for each bond considering the early redemption. The total additional cost comes to $100,000 ($2 * 50000 bonds). -So the net savings for ABC Corp is $200,000 ($300,000 -$100,000).
Types of Callable Bonds
Below are the different types of Callable Bonds:
- Optional redemption: In this issuer has the option to redeem the bonds at their will after a certain period. For E.g. Municipal bonds have the optional call feature where they can be redeemed after a certain period at the option of the issuer, which is usually 10 years.
- Sinking Fund redemption: In this issuer has to redeem a certain amount of bond at fixed intervals in accordance with a predefined schedule.
- Extraordinary redemption: In this issuer can redeem the bonds early on happening of certain extraordinary events. (E.g.) If the bond is issued for any specific purpose like the construction of a plant and the same is discontinued due to an extraordinary event, then the bonds can be called.
Values
The value of callable bonds differs from regular bonds as they have an additional option to call the bonds early. The call option affects the price of the bond as the investors may lose the interest income in the future if the bonds are called. The following is the formula for callable bonds.
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Where,
- Price of regular bond: Price of the Straight bond (Plain vanilla bond) that pays interest to the investors at fixed intervals, and the principal is repaid on maturity.
- Price of Call option: The price considered for availing the benefit of redeeming (Call option) the bond before maturity. It is the opportunity cost for the investors.
Callable Bonds Risk
In this case, both issuer and investors may encounter certain risks. In the case of the issuer, the coupon or interest rates can be a little higher in the case of callable bonds, and also, if they call it early, they will pay the price higher than the par value. Callable bonds are favorable only when the interest rates reduce in the future, and the issuer can call the bonds if the interest rate increase in the future, then the issuer ends up paying higher interest to the investor than the non-callable bonds, and also they don’t enjoy any benefits since they won’t call the bonds considering the higher interest rate in the market.
In the case of investors, if the bonds are called, then the investor may lose the interest income, and when they reinvest, they may fetch only lower interest rates which leads to lower interest income. Moreover, the reinvestment risk also applies with respect to the new bond’s price, where the price of the bond could be trading higher than the original callable bonds, and they may get lower income from a high investment. Therefore, it may not be suitable for investors who need stable and secured income.
Why are Callable Bonds issued?
Callable bonds are issued by the corporates considering the flexibility it provides to the issuers. They can call the bonds anytime they want during the bond tenure by paying the price higher than the par value. This is chosen predominantly in the economy where the interest rates are volatile, and it is expected to reduce in the future.
With the help of callable bonds, the corporates can refinance their debt from the market with a lower interest rate and pay off the investors. This could help the company save on the interest cost; otherwise, they would pay higher interest to the investors when funds are available at lower rates in the market.
Benefits
- Callable bonds pay higher interest to the investors as the issuer has the option to call the bond anytime they want.
- This debt instrument is more flexible to the issuer as they can call the bonds anytime, and also they can move to any lower interest rate instrument when the interest rate falls in the market.
- It is one of the easier ways to source funds for the business.
Disadvantages
- Investors will be at a disadvantage as once the bonds are called back; the investors may have to move to low-interest investments.
- There is no advantage for investors when the interest rate in the market increases, as the option to call the bonds is only with the issuer and not with investors.
- It pays higher returns than non-callable bonds considering the flexibility; it adds up to higher finance costs to the company.
Conclusion
Callable bonds are preferred in an economy where the interest rates are volatile, and it is expected that the interest rates may fall in the future. It gives the issuer an option to call the bonds before maturity, and to compensate for this; investors are paid a little higher interest than the market rate. Both issuers and investors carry certain risks, and the investment plan has to be decided based on the needs and expectations.
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