Callable (or Redeemable) Bonds: Definition, Types, Examples, Working & Formula
Callable bonds, also known as redeemable bonds, offer a fascinating dimension in fixed-income securities. These are types of bonds that can be redeemed or paid off by the issuer before they reach the date of maturity. In this article, you are set to explore the intricate nature of these bonds, understanding their meaning, how they operate, and real-world examples.
By delving into the details, we’ll uncover the implications for both issuers and investors, examining the flow of money, the utilization of funds, and the varying conditions under which callable bonds might be an attractive option for both parties.
What Are Callable Bonds?
Callable bonds are a type of fixed income bonds with an embedded call option which gives issuers the right to redeem such bonds before their maturity dates. However, the issuing entities are not under any obligation to redeem them before the expiry.
However, these bonds usually come with certain conditions agreed upfront by the Issuer at the time of issue of such bonds, like a particular time period in their lifespan under which redemption cannot happen. Moreover, some bonds will be eligible for redemption only in extraordinary situations. These bonds allow issuing entities to pay off their debts earlier than the stipulated time.
Companies usually use the premature redemption option when market interest rates fall below the coupon rate on these bonds. They redeem the existing bonds and borrow again from markets at a lower interest rate. Now that you are aware of the meaning of callable bonds let’s move on to its other aspects.
What Are the Features of Callable Bonds?
Here are some of the features of callable bonds:
- The par or face value of these bonds is generally lower than the call value.
- The underlying asset has a variable lifespan.
- Callable bonds have one of the highest interest rates. This is offered as compensation for investors, as issuers have a right to call back the bond anytime before maturity.
- Higher interest rates represent the premium of options sold by bondholders.
How Do Callable Bonds Work?
These are debt instruments in which bond issuers are bestowed with a right to prematurely pay off the requisite principal amount. Therefore, the issuing entity can stop the fixed interest that they were liable to pay for the entire timespan of the bond.
The offering document of every bond specifies terms and conditions about the recall that companies can execute. Generally, entities go for a bond issuance when they require funds for expansion or paying off their existing loans. A callable bond will help issuers to take advantage of falling market interest rates, as they can prematurely redeem these bonds and opt for other financing alternatives at more beneficial terms and conditions.
They are generally redeemed at a higher value than the debt’s par or face value. A bond recalled early on during its lifespan may have a higher call value. Whereas bonds recalled during the final stages of their tenure will come with lower call values.
For example, let’s say that a bond maturing in 2035 is available for premature redemption in 2023. The called price is 105. It means that for every ₹1000, bondholders or investors will receive ₹1050 in 2023. However, as time goes on, the call value will decline, and in 2024 it may come down to 103.
What Are the Types of Callable Bonds?
Here are the various types of callable bonds available for investment:
These bonds are issued by various urban local bodies like municipal corporations or municipalities. They come with a call feature which issuers can exercise only after completion of a certain time period, like 5 years or 10 years.
- Sinking Fund Bonds
These bonds require issuing entities to conform to a particular schedule while redeeming a part or complete debt. On some specific dates, companies or bond issuing organisations will have to repay partial amounts to investors. One of the main advantages of these bonds is that it saves companies from paying a lump sum money on redemption.
- Extraordinary Bonds
As the name goes by, an extraordinary bond allows for extraordinary redemption. Companies can only redeem these bonds before the maturity date on the occurrence of particular events, like if an approved or funded project gets damaged or delayed.
Example of Callable Bonds
Let’s discuss an example of a callable bond which will help you understand this concept more clearly:
Let’s say XYZ Limited has issued a bond whose face value is ₹10,000. The coupon rate offered by XYZ Limited to bondholders stands at 7.5%. However, prevailing market rates are 5%, and tenure of these debt instruments is 15 years.
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. Now, if after the completion of six years, market interest rates fall below coupon rates, the company will go for redemption and refinance its debt with a newer set of bonds at significantly lower coupon rates.
Now, if you were an investor in these bonds, it means that you would receive the principal amount much earlier than the stipulated date. But you will lose out on attractive interest which you would have received till the scheduled maturity.
However, in case market interest rates do not increase and go above the coupon rate, XYZ limited will not call back their issued bonds. In this case, the recall option or premature redemption option will expire unexercised.
What are the Advantages and Disadvantages of Callable Bonds?
Advantages of Callable Bonds:
Flexibility for Issuers: Issuers can retire debt early, especially when interest rates fall, allowing them to issue new bonds at lower rates.
Potential Higher Coupon Rates: Callable bonds typically offer higher coupon rates than non-callable bonds to compensate for the call risk.
Reinvestment Opportunities: If the bond is called, investors receive their principal back before maturity, providing an opportunity to reinvest in other securities.
Disadvantages of Callable Bonds:
Reinvestment Risk: Investors face the risk of having to reinvest their returned principal at lower interest rates if the bond is called when rates have fallen.
Uncertainty of Cash Flows: The possibility of early redemption adds uncertainty to the bond’s cash flows, making future planning challenging for investors.
Price Ceiling: The price appreciation of callable bonds is generally capped because the likelihood of the bond being called increases as interest rates fall and the bond’s price rises.
How to Calculate the Value of Callable Bonds?
You can determine the value of callable bonds by using the following formula:
Price of callable bond = Price of conventional vanilla bonds – Price of a call option.
Here, price of the call option refers to the value of call options allowing the issuer to redeem the bond before maturity.
The other variable refers to the price of a standard vanilla bond, which is similar in structure to a callable bond.
Callable bonds are a distinct set that assigns the issuer the right to redeem this instrument before the stipulated maturity date. However, it is completely up to the bond issuers whether they wish to proceed with premature redemption. They are under no obligation to go for it.
If you are looking to invest in a callable bond, you should do this after carefully analysing the bond document that explains all the terms and conditions of recall.
Frequently Asked Questions
What are the advantages of issuing a callable bond?
One of the major benefits of issuing a callable bond is that it offers companies the option of restructuring their debts. On the other hand, callable bonds also offer a high rate of interest to bondholders as compared to traditional bonds.
What are some examples of non-callable bonds?
Examples of non-callable bonds are treasury notes and treasury bonds. As the name suggests, these instruments are issued by governments.
What are the factors to consider before issuing callable bonds?
The factors that issuing bodies should consider before issuing callable bonds are timing and price. The former represents when the company should recall a particular bond, whereas the latter depicts the price needed before redeeming them.
What is call protection?
It refers to a clause in callable bonds which prohibits issuers from redeeming these instruments prematurely for a particular time period. Suppose a bond has a call protection clause of 5 years. It indicates that issuers cannot buy back such bonds before completion of 5 years from date of issue.
What are vanilla bonds?
Vanilla or plain vanilla bonds are the most basic type of bonds that have a fixed coupon payment at pre-set fixed intervals. These are standard bonds that have a predetermined maturity date.
Do investors like callable bonds?
Investors might have mixed feelings about callable bonds as they offer higher coupon rates but also have reinvestment risks and uncertainties.
How often are callable bonds called?
Callable bonds are often called when interest rates fall significantly, making it financially beneficial for the issuer to refinance the debt at a lower cost.