What Is a Callable Bond?

A callable bond is a bond that can be redeemed by the issuer prior to its maturity. A callable bond allows companies to pay off their debt early and benefit from favorable interest rate moves. A callable bond benefits investors with an attractive interest rate or coupon rate. A callable bond is also referred to as a redeemable bond.

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Callable Bond

Callable Bonds Explained

A callable bond is a debt instrument in which 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 2030 can be called in 2020. 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. For example, a bond callable at a price of 102 brings the investor $1,020 for each $1,000 in face value, yet stipulations state the price goes down to 101 after a year.

Interest Rates and Callable Bonds

If interest rates have declined since the bond was issued, the company can issue new debt at a lower interest rate than the callable bond. The company uses the proceeds to pay off the callable bonds by exercising the call feature. As a result, the company has refinanced its debt by paying off the higher-yielding callable bonds with the newly-issued debt at a lower interest rate.

Paying down debt early by exercising callable bonds saves a company interest expense and prevents the company from being put in financial difficulties in the long-term if economic or financial conditions worsen. 

However, the investor might not make out as well as the company when the bond is called. For example, let's say a 6% coupon bond is issued and is due to mature in five years. An investor purchases $10,000 worth and receives coupon payments of 6% x $10,000 or $600 annually. Three years after issuance, the interest rates fall to 4%, and the bond is called by the issuer. The bondholder must turn in the bond to get back the principal, and no further interest is paid.

The bondholder not only loses the remaining interest payments but may be unable to match a bond that pays 6% in the current interest rate environment. The investor might choose to reinvest at a lower interest rate and lose potential income. As a result, a callable bond may not be appropriate for investors seeking stable income and predictable returns.

Types of Callable Bonds

Callable bonds come with many variations. Optional redemption lets an issuer redeem its bonds according to the terms when the bond was issued. However, not all bonds are callable. Treasury bonds and Treasury notes are non-callable, although there are a few exceptions.

Most municipal bonds and some corporate bonds are callable. A municipal bond has call features that may be exercised after a set time period such as ten years.

Sinking fund redemption requires the issuer to adhere to a set schedule while redeeming a portion or all of its bonds. A sinking fund helps the company save money over time to avoid a large lump-sum payment to pay off the bond at maturity. A sinking fund has bonds issued whereby some of them are callable in order for the company to pay off its debt early.

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 refers to the time period when the bond cannot be called. The issuer must clarify whether a bond is callable and the exact terms of the call option, including when the timeframe as to when the bond can be called.

Key Takeaways

  • A callable bond is a bond that can be redeemed by the issuer prior to its maturity.
  • A callable bond allows companies to pay off their debt early and benefit from favorable interest rate moves.
  • A callable bond benefits investors with an attractive interest rate or coupon rate. A callable bond is also referred to as a redeemable bond.

Real World Example of a Callable Bond

Let's say Apple Inc. (APPL) decides to borrow $10 million in the bond market and issues a 6% coupon bond with a maturity date in five years. The company pays its bondholders 6% x $10 million or $600,000 in interest payments annually.

Three years from the date of issuance, interest rates fall by 200 basis points to 4%, prompting the company to redeem the bonds. Under the terms of the bond contract, if the company calls the bonds, it must pay the investors $102 premium to par. Therefore, the company pays the bond investors $10.2 million, which it borrows from the bank at a 4% interest rate. It reissues the bond with a 4% coupon rate and a principal sum of $10.2 million, reducing its annual interest payment to 4% x $10.2 million or $408,000.

Pros and Cons of Callable Bonds

Pros

  • A callable bond benefits investors by paying them a higher coupon or interest rate than a non-callable bond.

  • Callable bonds are beneficial to companies since investor-financed debt provides greater flexibility with the terms of the debt as compared to banks.

  • Callable bonds help companies raise capital, albeit at higher yields than non-callable bonds. However, companies can refinance their debt when rates fall by exercising the call feature.

Cons

  • Bonds are usually called when interest rates fall exposing the investor to reinvestment risk, which involves reinvesting the principal at a lower interest rate.

  • Investors lose out on favorable moves in interest rates. If rates rise beyond the bond's coupon rate, the company will not call the bonds leaving the investor holding a lower yielding bond relative to the market.