Callable Bonds

Definition

Callable bonds are a type of bond that allows the issuer to redeem the bond before its maturity date. This gives the issuer the option to repay the bond early, which can be advantageous if interest rates decline, allowing the issuer to refinance at a lower rate.

5 Must Know Facts For Your Next Test

1. Callable bonds typically offer a higher coupon rate than non-callable bonds to compensate investors for the risk of early redemption.
2. The call provision gives the issuer flexibility to refinance the bond if interest rates decline, but it also exposes investors to reinvestment risk.
3. Callable bonds are more sensitive to changes in interest rates than non-callable bonds, as the value of the call option is affected by interest rate movements.
4. The call premium, which is the amount paid to bondholders above par value when the bond is called, can vary depending on the bond's terms.
5. Yield to call is an important consideration for investors in callable bonds, as it reflects the yield they will receive if the bond is called on the first possible call date.

Review Questions

• Explain how the call provision in callable bonds affects the bond's characteristics and valuation.
  • The call provision in callable bonds gives the issuer the right to redeem the bond before maturity, typically if interest rates decline. This can be advantageous for the issuer, as it allows them to refinance at a lower rate. However, it exposes investors to reinvestment risk, as they may have to reinvest the proceeds at a lower yield. The call provision also makes callable bonds more sensitive to changes in interest rates, as the value of the call option is affected by rate movements. Investors in callable bonds must consider the yield to call, which reflects the yield they will receive if the bond is called on the first possible call date, rather than holding it to maturity.
• Describe the relationship between callable bonds and interest rate risk.
  • Callable bonds are more sensitive to changes in interest rates than non-callable bonds due to the presence of the call provision. When interest rates decline, the value of the call option embedded in the bond increases, making the bond more valuable to the issuer. This increased likelihood of the bond being called exposes investors to reinvestment risk, as they may have to reinvest the proceeds at a lower yield. Conversely, when interest rates rise, the value of the call option decreases, and the bond's value falls more than a non-callable bond with the same maturity and coupon. As a result, callable bonds have a higher interest rate risk profile compared to non-callable bonds.
• Analyze how the call premium and yield to call affect an investor's decision to purchase a callable bond.
  • The call premium and yield to call are crucial factors that investors must consider when evaluating callable bonds. The call premium is the amount the issuer must pay bondholders above the bond's par value when exercising the call provision. A higher call premium can help compensate investors for the risk of early redemption. The yield to call, on the other hand, reflects the yield an investor will receive if the bond is called on the first possible call date, rather than holding it to maturity. A higher yield to call can make a callable bond more attractive to investors, as it provides a better return if the bond is called. However, investors must weigh the potential for higher returns against the risk of reinvestment if the bond is called. The interplay between the call premium, yield to call, and the likelihood of the bond being called is a critical consideration in the decision to purchase a callable bond.

Related terms

Call Provision: The contractual clause that gives the bond issuer the right to redeem the bond prior to its maturity date.

Call Premium: The amount the issuer must pay bondholders in addition to the bond's par value when exercising the call provision.

Yield to Call: The yield an investor will receive if the bond is called on the first possible call date, rather than holding it to maturity.