Definition
A callable bond is a debt security that gives the issuer the right (but not the obligation) to repay the bond’s principal before the stated maturity date. The issuer “calls” the bond, stops future coupon (interest) payments, and returns principal to bondholders according to the call terms set when the bond was issued.
How the feature works (short)
– At issuance the bond prospectus specifies: when the issuer may call the bond (call dates), the price paid at call (call price), and any call-protection period (a time during which the bond cannot be called).
– Issuers commonly call bonds when market interest rates fall, enabling them to refinance at lower rates.
– Because the call option is valuable to the issuer, callable bonds tend to offer higher coupons (interest rates) than equivalent non‑callable bonds to compensate investors.
Key terms
– Call price: the amount paid to the bondholder if the bond is redeemed early, often expressed as a percentage of par (for example, 102 = $1,020 per $1,000 par).
– Call premium: the amount above par that the issuer pays on a call (call price minus 100% par).
– Call protection (or call deferment): initial period during which the bond cannot be called.
– Reinvestment risk: the risk that cash returned on a called bond (coupon or principal) must be reinvested at a lower prevailing rate.
Common types of call/redemption features
– Optional redemption: issuer may call bonds under the stated schedule and prices.
– Sinking fund redemption: issuer must retire a portion of the debt according to a pre-set schedule; sometimes the sinking-fund method involves callable issues.
– Extraordinary redemption: issuer can call bonds if certain events occur (e.g., physical damage to a project funded by the bond).
Note: U.S. Treasury notes and bonds are generally non‑callable; many municipal and corporate bonds can include call provisions.
How interest rate changes affect callable bonds
– Rates fall: issuers are more likely to call outstanding high-coupon bonds and replace them with cheaper debt. Investors receive principal earlier and must reinvest at lower yields.
– Rates rise: issuers are less likely to call; investors keep the higher coupon but the market price of the bond typically falls if sold before maturity. Callable bonds thus limit upside price gains when rates fall (because issuer calls) and expose investors to price declines when rates rise.
Pros and cons — issuer vs investor
– Issuer advantages: flexibility to refinance when market rates drop; avoids long-term commitment to higher coupon payments.
– Issuer trade-off: must pay a higher coupon initially to attract investors.
– Investor advantages: higher coupon than comparable non-callable issues (compensation for call risk).
– Investor disadvantages: reinvestment risk if the bond is called