A normal bond can be issued with embedded options. One such bond is a callable bond. A callable bond is like a normal bond but with an embedded call option which gives the issuer a right to recall the bond before its actual maturity is over. So, basically, a callable bond has two lives – one is its normal maturity and the other is when it is called by the issuer. Since a callable bond gives additional benefit to an issuer, he has to pay a premium to get this benefit. That’s why a callable bond has a higher coupon rate than a normal bond. In addition, the issuer may pay a premium to the bond’s par value if it is called before maturity. All these conditions are explicitly mentioned in the bond indenture beforehand.
One important consideration to note here is the conditions surrounding an early redemption of a callable bond. If an issuer has issued long-term bonds during a specific interest rate environment, and if the interest rates fall in the future, it makes sense for the issuer to re-issue debt at those lower rates. So, he will prefer to retire the older high coupon debt and issue new debt at lower rates. This is the benefit that having a call option on the bond gives the issuer, the specific time periods during which the bonds can be recalled may also be specified in the bond indenture.
Callable Bond Characteristics: A callable bond can be described by the following characteristics:
- Embedded Option: A callable bond has an embedded call option. This call option also has some value. So, the value of the callable bond is lower than that of a normal bond.Value of Callable Bonds = Value of Normal Bond – Value of Call Option
- Life: A callable bond has two lives. One is the normal maturity and one is the shorter life it experiences upon exercise of the call option.
- Yield: As with two lives, a callable bond also has two yields
- Yield to Maturity: This is the yield of the bond if it is held till maturity. It is same as the yield of a normal bond with similar coupon and maturity.
- Yield to Call: This is the yield if the bond is called before maturity. It can be estimated if we know the callable windows during the bond’s life and the value at which it will be called.
Callable Bond Uses: Callable bonds give the issuer an opportunity to refinance its debt at an attractive rate. It can also provide a natural hedge if the issuer has floating rate linked cash inflows from its assets. For the investors, it gives them an opportunity to earn higher than the normal coupon rate for at least the life of the bond. They also have a new asset class to diversify their portfolio.
Reinvestment Risk: Callable bond investors face reinvestment risk if the bond is called away when the interest rates are low. If an investor has an opportunity to invest in either a normal bond yielding 5% or a callable bond yielding 7%, he may choose to invest in the callable bond because of its attractive yield. Now, if the interest rates fall to, say 2.5%, the issuer of callable bonds will recall the bonds and reissue new debt instruments at the lower 2.5% rate.
Now, the investor will have to invest in the lower rate issues, even if he decides to invest in the debt issues of other companies because the interest rates in the whole economy would have fallen. So, the investor is reinvesting at a lower rate of return and facing a reinvestment risk if he invests in callable bonds.