Callable Bond

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Definition: Callable Bond

Callable Bond

What is the dictionary definition of Callable Bond?

Dictionary Definition

callable bond is a bond that can be called (redeemed) by the issuer prior to its maturity, on certain call dates, at the call price. In other words, on the call dates, the issuer has the right, but not the obligation, to buy back the bonds from the bondholders at the call price. Technically speaking, the bonds are not really bought and held by the issuer, but cancelled immediately.

Call price will usually exceed the par or issue price. In certain cases, mainly in the high-yield debt market, there can be a substantial premium.

The issuer has an option, for which he pays in the form of a higher coupon rate. If interest rates in the market have gone down at the time of the call date, the issuer will be able to refinance his debt at a cheaper level, so will call the bonds. Another way to look at it is that as interest rates have gone down, the price of the bond has gone up. Therefore, it is advantageous to buy the bonds back at the par.

The investor has the benefit of a higher coupon than he would have had with a bullet (non-callable) bond. On the other hand, if interest rates go down, the bonds get called, and he can only invest at the lower rate. This is comparable to selling an option—you get a premium upfront, but you have a downside if the option gets exercised.

The largest market for callable bonds is that of issues from the government-sponsored entities, better know as U.S. Agencies. They own a lot of mortgages and mortgage-backed securities. In the U.S. mortgages are usually fixed rate, and can be prepaid early without cost, contrary to other countries. If rates go down, a lot of homeowners will refinance at a lower rate. This means that the Agencies lose assets. By issuing a large number of callable bonds, they have a natural hedge, as they can then call their own issues and refinance at a lower rate.

Full Definition of Callable Bond

A callable bond (or redeemable bond) is a bond whose indenture includes one or more call provisions providing for the early retirement (“call” or “redemption”) of the bond. Call provisions may provide for optional redemption, extraordinary redemption or sinking fund redemption. When included in a bond’s indenture, extraordinary and sinking fund redemption are “boilerplate” provisions that usually afford the issuer little opportunity to benefit at investors’ expense. Form an investment standpoint, it is optional redemption that is interesting or a cause for concern. This article focuses exclusively on callable bonds with optional redemption provisions.

Such callable bonds are especially popular in the United States, where corporate bonds and municipal bonds are often callable. US Treasuries generally are not callable. Most callable bonds are coupon bonds. Convertible bonds are often callable. Zero-coupon bonds sometimes are.

A call provision need not be exercised to the bond holder’s economic detriment. For example, an issuer might exercise a call provision to retire a secured bond whose indenture places unwanted restrictions on the sale of collateral. This might be inconvenient for investors, but it would do them little economic harm. Such redemptions are rare. Generally, a bond is called when it is economically beneficial for the issuer to do so—and economically detrimental to bondholders. The typical scenario is that interest rates fall, so the issuer calls the bonds and issues new bonds at the lower interest rates. Such a transaction is called a refunding. It benefits the issuer, but investors are forced to surrender their high-coupon bonds and reinvest in the lower interest rate environment.

In the secondary market, callable bonds don’t exhibit the same price sensitivities as non-callable bonds. If interest rates drop, a non-callable bond’s market price will rise. This tendency is muted in a callable bond, since falling interest rates make it likely that the bond will be called. Once the first call date has passed, the bond’s clean price won’t generally rise above the call price.

A callable bond can be thought of a non-callable bond bundled with a short call option on that non-callable bond:

callable bond = non-callable bond – call option

The bondholder is short the call option, and the issuer is long the call option. The option has economic value, so the issuer compensates investors with a higher nominal yield than would be payable on a comparable non-callable bond. That higher yield is like an option premium the issuer pays the bondholder for the call option.

The bundled short call option makes callable bonds very difficult to analyze. The yield on a non-callable bond depends upon interest rates and the issuer’s credit quality. The yield on a callable bond depends upon both of these and the value of the embedded call option. This makes yields on callable and non-callable bonds not directly comparable. Also, yields on two callable bonds cannot be directly compared either, since their call features may differ in terms of call protection, call schedules and the degree to which the call options are in-the-money or out-of-the-money. Further complicating matters, the value of the call option depends on the volatility of interest rates, which can change unpredictably.

There is also the question of what metric of yield to consider when comparing bonds. Nominal yield and current yield are problematic with any bond. While yield to maturity is useful for comparing non-callable bonds, it is somewhat meaningless for callable bonds—which may be called long before they mature. Yield metrics designed specifically for callable bonds—such as yield to first call or yield to worst—offer an indicating of value that is crude at best.

A sophisticated analysis of callable bonds requires the use of financial engineering techniques that simultaneously value the credit risk, interest rate risk and optionality of a callable bond. Few investors have the resources to perform such analyses, although bond dealers generally do.

Synonyms For Callable Bond

Redeemable bond

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March 01, 2024
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Definition Sources

Definitions for Callable Bond are sourced/syndicated and enhanced from:

  • A Dictionary of Economics (Oxford Quick Reference)
  • Oxford Dictionary Of Accounting
  • Oxford Dictionary Of Business & Management

This glossary post was last updated: 29th December, 2021 | 0 Views.