man holding callable bonds

Callable Bonds – How They Work

Callable bonds are bonds that the issuing corporation can redeem before maturity. If you hold a callable bond and the issuer decides to redeem it you will have to surrender the bond.

Not all bonds are callable. The bond indenture must contain a call provision to allow for it if the issuer want to redeem the bonds early.

Why Would a Company Call a Bond?

A bond represents a debt of the issuing corporation. If you bought the bond, you have loaned money to the corporation and the corporation must repay you.

Like with any loan arrangement interest is involved. The company that borrowed the money by issuing the bond must pay interest on the loan. That’s what the coupon payments are. Every six months the company pays a portion of the interest on the loan to the person that loaned them the money (i.e. bought the bond).

The interest rate that the company pays is a function of many variables. The company’s credit-worthiness, how long the loan is for, and the going market interest rate at the time the bond was issued are all key factors. The interest rate the company pays is stated at the time of issuance and in most cases remains fixed for the life of the bond.

Over time, however, those factors can change…

If the company’s credit-worthiness improves after issuing bonds, the rate it could now borrow money for may improve.

Other times, the Fed may adjust the target for the Fed Funds rate as the economy changes, and in turn create a trickle effect in which other interest rates change too. When the economy is in a slump the Fed often reduces rates to help spur economic activity. When that happens companies can borrow more cheaply than they could before.

These are just examples. The point is that interest rates can change, either positively or negatively. When interest rates go down, borrowing becomes cheaper.

If it is now cheaper to borrow the corporation would rather pay the lower rate of interest by retiring old bonds and issuing new bonds at the current lower rate. Conceptually, it’s the same as you wanting to refinance a mortgage when rates drop.

If Rates Drop Will My Bond Be Called?

Not necessarily. When a company issues a new bond offering there are cost involved. There is an underwriting process, legal documents have to be drafted, and brokers have to be compensated for getting the bonds out to investors.

Before a bond is called, the company (or municipality since many municipal bonds are callable) has to be sure that the interest savings on the new issue would be enough to cover all those expenses. Often, if the new interest rate is less than 1% lower then it isn’t cost-effective to call the bond.

Are There Other Reasons a Bond May Get Called?

Yes. Some bond issues are structured so that a portion of the bonds are called periodically before maturity. The indenture may contain a sinking fund provision that stipulates money is set aside to purchase some of the bonds each year. This is actually a safety feature because it prevents the company from having to retire the entire issue at once when it matures.

In a simplified example suppose a corporation raises $10 million by issuing bonds. Those bonds will mature in 10 years. The sinking fund provision may state that starting in the 5th year $1 million of the bonds will be called each year. Then, the corporation will only need $5 million to retire the remaining bonds when they mature in the 10th year.

What Happens When a Bond is Called?

When a bond is called you’ll receive a notice that the issuer has called your bond. The issuer will then return your principal along with any unpaid accrued interest and the call premium. At that point you’ll stop receiving interest payments, as you no longer hold the bond.

So what exactly does that look like?

Suppose you have a bond that pays a 4% coupon and has a $1,000 par value. The annual interest you’d receive on that bond would be $40. Since corporate bonds typically pay interest in 6-month increments you’d receive two coupon payments per year of $20 each. If you were to hold that bond until it matured you’d receive the $1,000 principal.

If the bond contains a call provision it will also explicitly state the call premium. The call premium is an extra amount above the maturity value that the company must pay in order to call a bond before maturity. It’s your compensation for having the bond called. The premium is stated as a percentage of the par value, such as 104%. If your bond is callable at 104% you’ll receive $1,040.

In the case of our example here, suppose your bond is callable at 104% and you are due 6 months of interest when the bond is called. You’d receive a total of $1,060.

What is the Return on Callable Bonds?

There are several ways to measure the return on bonds. You can use my bond price calculator to help you calculate them for any bond. The two most important in most cases are the yield to maturity and the current yield.

The current yield is simply the coupon payment as a percentage of the bonds price. It lets you know what rate you are getting on the current value of the bond.

Th yield to maturity is the return you’d get if you hold the bond until its final maturity date. It represents the total return of principal and interest.

There is a measure that is unique to callable bonds called the yield to call. It’s effectively the same measure as yield to maturity, but it measures total return if you hold the bond until it is called. It accounts for not only the interest payments and principal, but the call premium as well.

Knowing the yield to call before you buy the bond is a good idea. That way you know if the risk of having your bond called is worth it. If the yield to call is lower than the lowest acceptable rate of return to you, don’t buy the bond. It could be called later and you have no control over that.

Should I Buy Callable Bonds?

One of the main drawbacks to investing in a callable bond is the fact that the issuer can force you to give up the bond before you want to.

For that reason, callable bonds are not ideal investments when you need specific maturities. If you build a bond ladder for an income floor as part of a retirement withdrawal plan, callable bonds are not appropriate.

However, that doesn’t mean you should never buy a callable bond. Callable bonds often have attractive yields. The chance that a bond could be called is a risk to the investor. Bond issuers have to compensate investors for taking that risk.

You should evaluate a callable bond by first making sure it is an appropriate investment for your goals. If it is and you feel that the yield is enough to justify the investment then by all means include it in your portfolio.

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