Callable bonds give the issuer the chance to redeem bond issues early. In return, the buyer gets a bond with a higher coupon rate and likely a higher price upon redemption.
Investors can be forgiven for thinking that they have complete control over how long they own a security. But in the case of bonds, an investor can find herself with that debt instrument cancelled by the issuer.
This is known as the callable bond option. It has a maturity date, just like any other bond. However, the callable feature means that the issuer can notify investors that it plans to redeem the bond at some point prior to its maturity-at-par date. This can be risky for the investor looking for steady income.
Now, this doesn’t mean that the issuer – government, utility or corporation – can spring this as a surprise on the unwary investor. In fact, the issuer makes it crystal clear at the time the bond is issued that it retains the right to call in the bond early. This is also known as the redemption feature.
For example, the issuer might say it reserves the right to call the bond every five years. And the issuer would give appropriate notice that it intends to exercise that feature.
Why call it in?
Any entity wishing to raise money won’t want to pay a cent more than it has to. So, let’s say Consolidated Sheet Metal offers an issue with a coupon of five per cent. The company may decide that it is advantageous to call that particular bond in, cancel it, and issue another bond at, say, four per cent if it is convinced interest rates are going to fall. Or, perhaps the issuer’s credit rating has been given a boost, allowing it to go to market with a lower coupon on its bonds and pay off more expensive debt.
By the same token, a callable would make sense to the investor thinking that interest rates will remain unchanged – or even move higher. In such a scenario, the issuer would be unlikely to use its call option.
It doesn’t come cheap
A major advantage for the callable bond holder is that these instruments generally pay a higher coupon rate than bonds without that feature. And, in turn, if a bond is called in early, the call price is often greater than the par, or issue, price. For example, the callable bond may be issued at a par value of $1,000. But come redemption time, it could be called at $1,060.
In sum, bonds with a callable feature are attractive to investors because of the (usually) higher coupon rate and the prospect of a higher price when redeemed. But because you’re in effect looking at potentially two maturity dates, it could pose difficulties in planning your income stream.