What are callable bonds?

A callable bond is a special kind of bond. The company or government that issued the bond can “call” it. This means they have the right to pay back the money they borrowed early, before the bond is supposed to mature.

Why would they want to do this? Let’s say the bond has a high interest rate, like 6%. But now interest rates in the economy have gone down. The company could borrow money at a lower rate, like 4%. So they call the 6% bond and pay the bondholders back early. Then they can issue a new bond at 4% and save money on interest.

The bond issuer perspective

For the company or government issuing the bonds (called the “issuer”), having callable bonds gives them more flexibility. Imagine the issuer borrowed $1 million by issuing 10-year bonds at 6% interest. Each year they have to pay $60,000 in interest to the bondholders (6% of $1 million).

After 5 years, interest rates have fallen to 4%. The issuer realizes they could borrow that same $1 million but only pay $40,000 per year in interest instead of $60,000. So the issuer decides to call the bonds.

They notify the bondholders and pay them back the face value of the bonds, let’s say $1000 per bond, plus maybe a small premium since they’re being paid back early. The total they pay to call the bonds might be $1.05 million. Then they turn around and issue new 10-year bonds at 4% and lock in those lower interest payments.

So in this example, the callable bonds allowed the issuer to refinance their debt at a lower interest rate. This saves them money.

The bondholder perspective

But what about the people who bought those 6% bonds that got called early? For them, it’s usually not great news. Remember, they were expecting to keep earning that juicy 6% interest for 10 full years. Now suddenly after 5 years their bonds get called and they’re paid back early.

They have to take that money and reinvest it. But interest rates are lower now, so the best they can get is maybe 4%. They would have preferred to keep collecting that 6% for another 5 years!

This is the main downside of buying callable bonds. There’s always the chance that interest rates fall and your bonds get called early. You miss out on those high interest payments you were expecting.

To compensate investors for this risk, callable bonds usually have higher interest rates than non-callable bonds. The investors are essentially selling the issuer an “option” to pay them back early. For this option, the investors demand a higher interest rate.

When are bonds likely to be called?

Bonds are most likely to be called when interest rates fall significantly below the rate on the bonds. Like in our example, if a company has 6% bonds outstanding but rates drop to 4%, the company has a big incentive to call the bonds and refinance at 4%.

Bonds are unlikely to be called if interest rates rise above the rate on the bonds. Imagine a company has 4% bonds outstanding. Interest rates rise to 6%. The company is happy – their 4% bonds are now a bargain compared to the 6% they’d have to pay on new bonds. They have no reason to call the 4% bonds – they want to keep paying that lower rate as long as possible!

Call dates and prices

Callable bonds have specific dates when the issuer has the right to call them. These are laid out in the bond’s prospectus. An issuer can’t just call a bond whenever they feel like it.

The price the issuer has to pay to call the bonds is also specified. It’s usually the face value of the bond plus a premium. For example, a bond with a $1000 face value might have a call price of $1050. This premium compensates the bondholders a bit for having their bonds redeemed early.

Typically, the call premium starts out higher and then decreases as the bonds get closer to maturity. A bond might be callable at $1080 after 1 year, $1060 after 3 years, $1040 after 5 years, and so on. This gives bondholders some protection – the issuer really has to pay up to call the bond early on.

Call protection

Bondholders can get some extra protection from early calls through provisions known as “call protection.” The simplest form is a set period, maybe 5 or 10 years, during which the issuer simply cannot call the bonds at all. This is a hard protection for bondholders.

Another form of call protection is to make the call price very high in the early years. So maybe a bond is technically callable right away, but the issuer has to pay bondholders $1200 to call it in the first 3 years, then $1100 through year 5, then $1000 after that. This high cost discourages the issuer from calling the bond early on.

Call protection can make a bond more attractive to investors. They know their higher interest payments are locked in for at least a certain period. But it’s a tradeoff – more call protection usually means a lower interest rate on the bond. Investors are selling a less valuable call option to the issuer.

The interest rate view

You can think of a callable bond from an interest rate perspective too. A callable bond has two components:

1. A noncallable bond with the same maturity and coupon rate
2. The issuer owns call options that let them buy back the bond at specified prices on specified dates

The interesting twist is that those call options increase in value as interest rates fall. Remember, the issuer wants to call the bonds when rates fall. So the value of their call options goes up as rates decline.

But for the bondholder, those call options are a negative. The bondholder has essentially sold call options to the issuer. If rates fall and the bonds are called, the bondholder loses out on the high interest payments they were expecting.

So a callable bond yields less than an equivalent noncallable bond. The yield reduction is the cost of those call options the bondholder has sold to the issuer. The more likely the bonds are to be called, the bigger that yield reduction will be.

Advantages and disadvantages

The main advantage of callable bonds is they give flexibility to the issuer. If rates fall or the issuer’s credit improves, they can call the bonds and refinance at lower rates. This flexibility is valuable – that’s why issuers are willing to pay higher interest rates on callable bonds.

For investors, the higher yields are the main attraction of callable bonds. In exchange for the risk of having their bonds called, investors earn extra interest.

But that call risk is a big disadvantage. If your bonds get called, you have to reinvest at prevailing lower rates. You can lose a lot of expected future interest payments.

Callable bonds are also more complex to analyze and value. You have to make assumptions about interest rate paths and when the bonds might be called. Noncallable bonds are more straightforward – you just have the fixed coupon payments and the maturity value.