Callable Bonds – What Are they and How Do They Work?

Bonds are pretty simple investment tools. You will earn interest every year until the bond matures, but the interest you get depends on the interest rate and if it is a coupon or zero-bond. On the other hand, things start to get a little complicated and exciting when we talk about callable bonds.

Now, callable bonds tend to have what seems like a double life. They are, therefore, more complex and require a little more attention from you. In this piece, we shall go through everything you should know about callable bonds and how they differ from regular bonds.

Read through to the end to the end before you invest in bonds. Like with anything else in life, we recommend that you start with the end in mind.

 

What is a callable bond?

Callable bonds are also known as redeemable bonds. They are bonds that issuers can redeem before they hit the stated maturity. If you took a payday loan, there are three options when it comes to repayment. You could be late in payments, on time or early. If you make a late repayment, you attract a fine. Early repayments, on the other hand, helps you save money you’d have spent on interest. The same case applies to issuers and bonds.

When dealing with callable bonds, they have the option of paying off the bond (debt) early. A business can opt to call the bond if the prevailing interest rates are favorable and will allow them to borrow more money at better rates. But what’s in it for the investor? With callable bonds, you get to benefit because they typically come with attractive interest or coupon rates owing to their callable option.

How does a callable bond work?

You can think of a callable bond like a debt that allows the issuer to return the investor capital (the amount owed) plus interest to save the business money before the bond matures. Generally, corporations usually avail bonds to the public to help fund their expansion or to pay off large debts fast. However, if the corporation expects the interest rates to decline soon, it will provide the bonds as callable. With this option, they can repay the loan to investors and secure other loans at lower interest rates. We know that this doesn’t sound fair, but it is.

Before you agree to callable bond terms, the corporation will provide a bond offering which will detail the specific of when the company can recall the bonds. Speaking of being fair, you should also note that a corporation will call its bonds at a value higher than the principal amount. The call amount is determined by when calling the bonds. The earlier it is in the life of the bond, the higher the call value and vice versa.

Let’s consider a bond has a maturity date in 2030. If it were callable, the issuer would call it in say 2021. It may have a callable value of 102. This means that you will receive $1,020 for every $1,000 bond invested. The bond details may also stipulate that the call price reduces to 101 after another year. This means that in 2022, you will get $1,010 for every $1,000 bond investment.

Types of callable bonds

Callable bonds are available in different variations. An optional redemption allows the corporation to redeem the bonds according to stipulated terms at the time of bond issuance.

Usually, corporate and municipal bonds tend to be callable. Municipal bonds have call features that are exercisable after a decade.

Sinking funds redemption are callable. However, the issuer should adhere to a specific schedule when redeeming part or all of its debt. On the dates specified on the bond offer, an issuer will call a portion of the bonds. The beauty of sinking funds is that it allows companies to save money in the process while staying away from the lump-sum payment, which may dent the company’s liquidity.

An extraordinary redemption allows a company to call the bonds before they hit maturity when specific events happen. For instance, when a running project is destroyed or damaged, it may trigger calling the bond.

Last but not least, call protection is the period when the company cannot call the bonds. For callable bonds, the company should always be clear on the terms of calling bonds. They should include the timeframe within which they can call the bonds. Outside of this timeframe bond calling is not possible.

Interest rates vs callable bonds

If, say the interest rates take a dip after the company puts the bonds on sale, they can provide another debt from which they will get an even lower interest rate in comparison to the original bond. The company can then use the money from the second debt to pay off the high-yielding callable bond while adhering to the features of the call described in the bond offer.  When a company pays off the debt early, it saves on interest expense and also saves itself from getting into inevitable financial constraints in the future if its financial situations continue.

On the other hand, you might not benefit as much as the company from calling the bond. Here is a quick example to give you a clear picture of what you should expect. Assume you have a 5% coupon bond set to mature in the next ten years.  If you purchase bonds worth $10,000, you will receive payments of $500 every year. Four years in, the bond’s coupon rate falls to 4%, and then the company calls its bonds. You will have to give up the bond in exchange for the original principal without getting interest for the remaining years paid.

Going with this example, it means that you’ll have lost the remaining coupon payments. Moreover, it is highly unlikely that the company will match the 5% coupon rate with the new bonds. This phenomenon is known as the reinvestment risk, so you choose to reinvest at a reduced rate and lose your potential income.

Aside from a lower interest rate, you may also have to purchase the new bonds at a higher price. This means you will pay more for a low-yielding bond. Because of this, callable bonds are not ideal for investors who are looking for stable and predictable returns.

Pros and Cons of Callable Bonds

Now let’s take a closer look at call protection.

Call Protection

It is a provision designed to protect a bond investor, and that limits the bond issuing company from calling back bonds until a specified time has elapsed. The period within which the bond is protected from calling is called the cushion or deferment. Callable bonds that have call protection are called deferred callable bonds.

Here are a few facts you need to have to go into this explanation. Bonds act as fixed-income investments and are from governments and corporations who need funds to complete specific projects. The bonds have maturity dates when the principal amount is repaid in full. As compensation for the loan, the bond earns interest which the issuer pays annually or semiannually.

Callable bonds are beneficial to the issuer, but it’s not always the case for you, the investor, as we saw above. But this doesn’t mean that you do nothing and await your doom. No, ygou have a chance to save your money and this is where call protection comes in. The idea of this protection is to protect bonds from being called in the early stages of their life. Usually, callable municipal and corporate bonds have 10-year call protections. On the other hand, utility debts have 5-year protections.

This means that if you buy a callable corporate bond with a 4% coupon rate and a maturity date set 15 years from today, the first call can only be after 10 years after which the interest rate drops to 3% for the remaining 5 years. During the first 10 years, investors are under call protection. If the interest rates continue to reduce after the decade, the corporation can trigger a call option within the provisions of the bond write up.

How to prepare for a call

When the interest rate drops, you expect a bond issuer to call their bonds – they will, after all, save money. As a bond investor, you can examine your bond portfolio and prepare for the loss. Consider the bond price; is it more than you initially paid? If it is, then it is better to sell it before the bonds are the call. Even if you will pay some tax to the government, you will still make a profit.

It goes without saying that you can only prepare for bond calls before they happen. If you have a freely-callable bond, you might not have time to prepare, but if you are under call protection, then, prepare for a call any time after the date.

Last but not least, you can employ some bond strategies to keep your portfolio safe from calling risks. One strategy you can use is laddering. Laddering is purchasing bonds with different maturity dates. So instead of buying one large bond with one maturity date, you buy smaller bonds with varying dates of maturity.  With this strategy, if some of the bonds get called, you’ll still have other bonds with several years left to maturity. They might be too young and hence still under call protection. The bonds that are closer to maturity will not be called because it will not make sense for the corporation to do so. For a corporation to release savings from the interest there have to be some years left to maturity; otherwise, the savings aren’t lucrative enough. Since the issuers will only call some of the bonds, your bond portfolio will be stable.

Convertible bonds vs. Callable bonds

A convertible bond has several features including face value coupon rate and expiration date. However, some additional rules give the investor the power to exchange a bond for several shares before the bond expires. The original bond price and the conversion rate are usually set in a way that it will only make sense to convert a bond with the price of stocks increases.

For instance, you can exchange a bond that has a face value of $100 with five shares, but you can only perform the exchange when the stock prices are above $20. This means that the value of the stock should have been below $20 when you were getting the bond. If not, then there wouldn’t be anything preventing you from converting the bonds into shares immediately they are on sale, thereby making bonds a useless investment.

Similarities between callable and convertible bonds

Both convertible and callable bonds have uncertain lifespans. For the case of callable bonds, the corporation can terminate the bond before it matures. On the flip side, a bond investor can do the same with convertible bonds.

With the two types of bonds, there is an opportunity to make windfall profits.  Also, with callable bonds, you get some compensation for the early recall of the bonds. For convertible bonds, early conversion can only happen if the said conversion is profitable.

Differences between callable and convertible bonds

The major difference between the two is the party that can act on the bonds. With callable bonds, the issuer decides when they will call their bonds, but this can only happen outside the call protection period. On the other hand, with convertible bonds, the investor decides when they want to convert their bonds.

Though the issuer can get windfall profits from both bond types, profit from convertible bonds is higher. With callable bonds, the prospectus specifies how much the issuer pays when calling for the bond, but with convertible bonds, the profits are unlimited. The higher the stock price, the higher the profit.

What you should know before buying callable bonds

What the yield on the bond will be if it were to be called at its earliest possible date. This is also known as the yield to call. If a callable bond was to sell at a price lower than its par value, then you would not mind when the issuer calls the bond. You would sell the bonds at a profit and reinvest the money into a bond with an even higher yield than the coupon rate.

If you own callable bonds whose market price is well below the call price, then you will hope the issuer doesn’t call the bonds. This is because you will take a loss and you might not find a bond with the same price.

Is the call an option or mandatory?

If the call is mandatory, then you should check if the issuer can buy the bonds instead of calling them. Generally, the call feature tends to favor the issuer. The best situation for an investor is when the bond is mandatory, and the issuer needs to redeem the bond at its face value regardless of the prevailing bond price. In this case, you will make a profit.

How to choose a bond broker

Whether you are dealing with regular bonds or callable bonds, you need to have the best bond broker on your side. But with so many bond brokers, how do you choose the best? Below are some tips to guide you through the choosing process.

Make sure the broker is regulated

Like with any professional service, you should first seek to determine whether the Financial Industry Regulatory Authority of the Securities Industry and Financial Markets Association regulates the broker. These bodies keep the brokers honest and on their toes.

Choose a specialized broker

There are many bonds you can invest in. To stand a better chance of earning a profit, you should use a bond broker who specializes in the bonds you are intent on purchasing. This is important because the markets are vast, and focus is critical in achieving success.

Always be on your guard

Even though you will be using a broker, it doesn’t mean that you will take a back seat in the investment. No, there is too much at stake to even think of it. Instead, you should make sure the broker is not charging you an insane mark-up, but the question is, how much is too much? Well, if the broker charges a mark-up higher than what you would make in three months from the bond coupons, you should skip the bond broker altogether.

Verdict

Corporations need money to expand and even settle some debts. At times they are forced to do so even when the interest rates are high. But the moment they drop, they decide to call them and save some money in the process.

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