What Are Callable Bonds? How They Work, 3 Types, 3 Pros & 3 Cons

By Chika

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Last Updated: May 18, 2022

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Bond investors lend money to businesses or issuers for a specified length of time in exchange for interest on the principal. By the maturity date of the bond, these corporations usually refund the borrowed principle to the bond holders.

The use of callable bonds, which allow the issuer to pay off its debts early by purchasing back its bonds before they reach maturity, is an exception to this bond investment method. A callable bond is one that includes a built-in call option.

 

What is a Callable Bond?

Callable bonds, also known as redeemable bonds, provide the issuer the option to redeem the bond before its maturity date, but not the obligation. The entity that issues callable bonds has the option to prepay the bond before its maturity date, or the bond is callable.

When interest rates are expected to decline, issuers may employ these types of bonds. They can then redeem their bonds and replace them with new ones with lower coupon rates, lowering their overall interest costs.

 

 

How Do Callable Bonds Work?

When an issuer calls a bond, it pays investors the call price, which is the bond's face value plus any accumulated interest.

After that, the issuer is no longer required to make bond payments. Callable bonds may be preferred by businesses because they feature built-in flexibility that might reduce expenses in the future. 

For example, if market rates are 5% when a corporation first issues bonds and then fall to 2.5%, a bond issuer paying 5% would call its notes and replace them with new ones paying 2.5%.

Call protection is a feature of some bonds that prevents the issuer from buying them back for a set length of time. During this time, the firm is unable to call its bonds.

The issuer can, however, redeem the bond at its designated call date at the conclusion of this time. Interest rates affect bond values because declining interest rates make them less valuable.

 

 

Pros & Cons of Callable Bonds

Callable bonds, like any other investment, have advantages and disadvantages. When planning a long-term investment strategy, evaluate the advantages and disadvantages of investing in callable bonds.

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.

 

3 Pros

The ability to call callable bonds early is one of its advantages. The issuer can recall the bond sooner rather than waiting until it matures to meet their financial business demands.

To compensate for the risk of early redemption, companies issue callable bonds with higher interest rates. This implies higher investment returns are possible.

Callable bonds provide a number of advantages that mostly benefit the issuer. When interest rates drop, the corporation may redeem the bonds and issue new bonds at a reduced rate, saving money on interest payments.

 

3 Cons

Bond investors risk not being able to find bonds with lower coupon rates if an issuer calls its bonds early due to reduced interest rates. This might be a problem for income investors looking for a consistent supply of passive income from bonds.

Investors that pay a premium or more than the face value of a callable bond risk just getting the face value back. This implies that the investor will lose money on the premium they have already paid.

The maturity of the bond is also a risk. The longer a bond waits to mature, the more likely it is to be called early, especially if interest rates fluctuate. Bonds having a shorter maturity date have a lesser chance of interest rate increases.

 

 

Interest and Callable Bonds

Falling interest rates provide a chance for bond issuers to recall their bonds and cut their interest rate. While the investor is initially rewarded with a greater yield or coupon rate for purchasing callable bonds, they must be aware of the additional risks involved.

If interest rates remain unchanged or rise, the issuer is less likely to recall its bonds. Investors should be rewarded for this increased risk if they predict interest rates will fall before the bond's maturity date.

The call feature benefits the issuer rather than the investor. So, the investor must decide if the greater return from callable bonds is worth the risk of investing.

 

 

3 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.

 

1. Optional Redemption Callable Bonds

Some municipal bonds have a 10-year redemption period after the bond was issued. Bonds with higher yields, on the other hand, may have a protection or waiting period based on the maturity date. A five-year bond, for example, may not be recalled until two years after it is issued.

2. Sinking Fund Redemption Callable Bonds

This requires the issuer to recall a specific number of bonds or all of them on a set period. A sinking fund is money set aside by a corporation to pay down a bond.

3. Extraordinary Redemption Callable Bonds

If certain stated circumstances in the bond contract occur, the issuer may recall the bond before maturity. This could include a business scenario that affects bond revenue.

 

 

The Takeaway

Some investors may consider buying callable bonds as a strategy to diversify their investment portfolio or increase income; however, they should be aware of the dangers involved with this investment.

Callable bonds may not be suitable for long-term income investors in an environment when interest rates are dropping.

 

 

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