Callable Bonds: Definition, Types, Working and Formula

Effective tactical use of callable bonds depends on one’s view of future interest rates. Keep in mind that a callable bond is composed of two primary components, a standard bond and an embedded call option on interest rates. Now, assume interest rates fall in five years so that Firm B could issue a standard 30-year bond at only 3%.

By issuing numerous callable bonds, they have a natural hedge, as they can then call their own issues and refinance at a lower rate. Sinking fund redemption requires the issuer to adhere to a set schedule while redeeming a portion or all of its debt. On specified dates, the company will remit a portion of the bond to bondholders. A sinking fund helps the company save money over time and avoid a large lump-sum payment at maturity.

Yield Curve Analysis

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. Three years from the date of issuance, interest rates fall by 200 basis points (bps) to 4%, prompting the company to redeem the bonds.

The issuer must clarify whether a bond is callable and the exact terms of the call option, including when the timeframe when the bond can be called. Optional redemption lets an issuer redeem its bonds according to the terms when the bond was issued. Treasury bonds and Treasury notes are non-callable, although there are a few exceptions. Investors achieve a small level of safety with bonds by locking in a desirable interest rate. A call not only throws a wrench into their investment plans, it means they have to buy another investment to replace it. Commissions or other fees add to the cost of acquiring another investment—not only did the investor lose potential gains, but they lost money in the process.

A Different Response to Interest Rates

Additionally, when interest rates increase more than the market rate, companies would keep the bonds till their maturity rate since they would be financing themselves with lower interest payments. However, when the market-rate decreases, the issuer can now call the bond and issue a new one to refinance their debt with a lower interest rate bond. This helps companies reduce their interest expenses and protect them against financial challenges. Issuers usually issue bonds with a call feature to raise money in a safer way in which they can call the bonds when interest rates go down and issue new ones with lower interest payments.

  • Paul Conley is an expert in investing and bonds with more than 30 years of experience in financial reporting, editing, and administrating.
  • Moreover, they serve a valuable purpose in financial markets by creating opportunities for companies and individuals to act upon their interest-rate expectations.
  • The transactions can be done simultaneously so that the funds from the new issues go to paying the existing investors that are holding the callable bonds.
  • Should this happen, you would have benefited in the short term from a higher interest rate.
  • These bonds are issued by various urban local bodies like municipal corporations or municipalities.

There is no free lunch, and the higher interest payments received for a callable bond come at the cost of reinvestment-rate risk and diminished price-appreciation potential. That makes callable bonds one of many tools for investors to express their tactical views on financial markets and achieve an optimal asset allocation. Callable bonds typically pay a higher coupon or interest rate to investors than callable bonds definition non-callable bonds. Should the market interest rate fall lower than the rate being paid to the bondholders, the business may call the note. This flexibility is usually more favorable for the business than using bank-based lending. However, this company issued the bonds with an inherent call option which allows companies to go for premature redemption of these bonds after six years of their issue.

Terms Similar to Callable Bond

For example, the bond may be issued at a par value of $1,000, but be called away at $1,050. The issuer’s cost takes the form of overall higher interest costs, and the investor’s benefit is overall higher interest received. Valuing callable bonds differs from valuing regular bonds because of the embedded call option.

callable bonds definition

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