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Course 202
Callable Bonds

Introduction

Owning a bond does not always entitle you to sit back and collect interest. If your bond is callable, it may not live to see maturity. That is why it is important to understand the callability feature of bonds. Callability can benefit both the investor and company.

What Is Callability?

When you were growing up, were you ever called home for dinner? Companies can sometimes "call home," or redeem, bonds they have issued prior to the bonds' maturity dates. Callability is the ability of a bond issuer to redeem its bonds early.

Callability is the ability of a bond issuer to redeem its bonds early. Some bonds--but not all--are issued with a call provision, described in the indenture, or agreement between the bondholder and the bond issuer, as well as in the bond's prospectus. The call provision outlines when the issuer may call the bond; often this date is 10 years after the bond has been issued.

For instance, a company may be able to call its 20-year bonds after 10 years. The call provision also outlines the price at which the bond will be called; generally this price equals or somewhat exceeds the par value, or face value, of the bond.

When you buy a bond, you will want to check whether the bond is callable. If it is, you also will want to learn the price the issuer will pay for a bond that it calls. You also should check the precise call date, since you cannot be sure of receiving interest income after that date.

The Characteristics of Callable Bonds

When a company may redeem a bond after a certain date, this callability is sometimes termed a deferred call. For instance, if you own a bond that may be called after five years, you own a bond with a deferred call provision. You may want to look for bonds that offer call protection--or some measure of time during which the bond may not be called.

If you own a bond that may be called at any time, you own a freely callable bond. In contrast, noncallable bonds cannot be called until maturity, and bonds with this feature offer the investor non-callability.

When you are considering purchasing a bond, you may want to determine the yield-to-call, which is the calculation of the bond's rate of return if it is called as soon as possible--in other words, at the call date. The yield-to-call takes into account the purchase price, redemption price, annual interest payments, and amount of time remaining to the call date.

For example, say that you purchased a $1,000 bond paying 10% interest, and that you paid a discounted price of $800 for the bond. It has a call date five years hence, when the company will pay you the bond's par value. To calculate the yield-to-call:

  • Subtract your price from the par value ($1,000 - $800 = $200)
  • Divide this figure by the number of years to callability ($200/5 = $40)
  • Add the annual interest payments ($40 + $100 = $140)
  • Add the price you paid to the par value, then divide by 2 (($800 + $1,000)/2 = $900)
  • Divide this figure into your answer for step 3 ($140/$900 = 15.5%)

Occasionally, a municipal bond might be redeemed through a catastrophe call, for example, following the destruction of a toll bridge that served as a revenue source to back the bond. In this extraordinary case, investors likely would be paid from funds received from an insurance policy on the bridge.

When deciding whether to invest in callable bonds, you will want to check for a call premium, the call date, yield-to-call, and other key factors before making up your mind.

Why Companies Issue Callable Bonds

The primary reason that companies issue callable bonds rather than non-callable bonds is to protect them in the event that interest rates drop. For instance, if a company issues bonds that pay investors the going rate of 7% annually in interest, and then the going rate declines to 6%, the company may redeem its callable bonds, replacing them with new bonds paying 6% annually.

This is especially crucial for bonds with maturity dates 20 years or more into the future. Without callability, a company might issue bonds with a high interest rate and not be able to change the rate for 20 years. The company could find itself locked into a high rate for many years at a time when new bonds are being issued with much lower interest rates. The company would be at a competitive disadvantage if it continued to finance its debts at the old, higher rate.

Companies are often willing to pay a premium to redeem the bonds before maturity, to avoid the above scenario. Callability enables the company to respond to changing interest rates, refinance high-interest debts, and avoid paying more than the going rates for its long-term debts.

Investor Benefits of Callable Bonds

For the investor hoping to receive interest from a bond for many years, a bond call can present a challenge. Now the investor must find another investment to replace the high-interest bond, at a time when the going interest rate is lower. While the investor may be able to find another type of investment paying a comparable return, he or she is unlikely to find a similar bond paying a comparable return.

The bond issuer sometimes pays the bondholder more than the par value of the bond when it is called.

To compensate the investor for this loss of income and the lost opportunity of owning the bond to maturity, the bond issuer sometimes pays the bondholder more than the par value of the bond when it is called. The amount that the issuer pays above the par value is termed the call premium, and often it is part of the price issuers pay for callability. The existence and amount of the call premium usually can be found in the bond prospectus and bond agreement. The amount of the call premium often approximates one year's interest at the call date. For example, if you own a $1,000 bond paying 9% interest annually and the company calls your bond at the call date, you might expect to receive $1,090 for the bond (par value plus $90). Sometimes, the amount of the call premium is reduced each year past the call date.

Bond Buyer Beware

Some investors may decide never to buy a callable bond; however, this isn't always practical. When deciding whether to invest in callable bonds, you will want to check for a call premium, the call date, yield-to-call, and other key factors before making up your mind. You may want to create several scenarios that compare your earnings for different call dates.

When you have completed your analysis, you will not be caught off guard if your bond is called. You will be prepared and know what steps to take to keep your investment plan on track.

Quiz 202
There is only one correct answer to each question.

1 When may a company redeem its callable bonds?
a. Before maturity
b. Upon maturity
c. 10 years after maturity
2 Todd just bought a bond with a call date of eight years in the future. What does his bond offer?
a. A call premium
b. Convertibility
c. Call protection
3 What is a bond's yield-to-call?
a. Interest rate
b. Maturity date
c. Rate of return
4 For companies, what is the primary advantage of callability?
a. Redeem bonds at less than par value
b. Refinance debts with a more favorable interest rate
c. Lock into favorable interest rates for the long term
5 When a bond issuer redeems a bond before maturity, how may the bondholder be compensated?
a. Call premium
b. Capital gains discount
c. Callable benefit
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