A callable bond (also called redeemable bond) is a type of
bond
Bond or bonds may refer to:
Common meanings
* Bond (finance), a type of debt security
* Bail bond, a commercial third-party guarantor of surety bonds in the United States
* Chemical bond, the attraction of atoms, ions or molecules to form chemical ...
(debt
security
Security is protection from, or resilience against, potential harm (or other unwanted coercive change) caused by others, by restraining the freedom of others to act. Beneficiaries (technically referents) of security may be of persons and social ...
) that allows the
issuer of the bond to retain the privilege of redeeming the bond at some point before the bond reaches its date of maturity. In other words, on the call date(s), the issuer has the right, but not the obligation, to buy back the bonds from the bond holders at a
defined call price. Technically speaking, the bonds are not really bought and held by the issuer but are instead cancelled immediately.
The call price will usually exceed the
par or issue price. In certain cases, mainly in the
high-yield debt market, there can be a substantial call premium.
Thus, the issuer has an
option
Option or Options may refer to:
Computing
*Option key, a key on Apple computer keyboards
*Option type, a polymorphic data type in programming languages
*Command-line option, an optional parameter to a command
*OPTIONS, an HTTP request method
...
which it pays for by offering a higher
coupon rate. If interest rates in the market have gone down by the time of the call date, the issuer will be able to
refinance its debt at a cheaper level and so will be incentivized to call the bonds it originally issued. Another way to look at this interplay is that, as interest rates go down, the present values of the bonds go up; therefore, it is advantageous to buy the bonds back at
par value.
With a callable bond, investors have the benefit of a higher
coupon than they would have had with a non-callable bond. On the other hand, if interest rates fall, the bonds will likely be called and they can only invest at the lower rate. This is comparable to selling (writing) an option — the option writer gets a premium up front, but has a downside if the option is exercised.
The largest market for callable bonds is that of issues from government sponsored entities. They own many
mortgages
A mortgage loan or simply mortgage (), in civil law jurisdicions known also as a hypothec loan, is a loan used either by purchasers of real property to raise funds to buy real estate, or by existing property owners to raise funds for any pu ...
and
mortgage-backed securities. In the U.S., mortgages are usually fixed rate, and can be prepaid early without cost, in contrast to the norms in other countries. If rates go down, many home owners will refinance at a lower rate. As a consequence, the agencies lose assets. By issuing numerous callable bonds, they have a natural hedge, as they can then call their own issues and refinance at a lower rate.
The price behaviour of a callable bond is the opposite of that of
puttable bond Puttable bond (put bond, putable or retractable bond) is a bond with an embedded put option. The holder of the puttable bond has the right, but not the obligation, to demand early repayment of the principal. The put option is exercisable on one or ...
. Since
call option
In finance, a call option, often simply labeled a "call", is a contract between the buyer and the seller of the call option to exchange a security at a set price. The buyer of the call option has the right, but not the obligation, to buy an ...
and
put option
In finance, a put or put option is a derivative instrument in financial markets that gives the holder (i.e. the purchaser of the put option) the right to sell an asset (the ''underlying''), at a specified price (the ''strike''), by (or at) a s ...
are not
mutually exclusive, a bond may have both options embedded.
Pricing
:: price of callable bond = price of straight bond – price of call option;
* Price of a callable bond is always lower than the price of a straight bond because the call option adds value to an issuer.
* Yield on a callable bond is higher than the yield on a straight bond.
References
External links
Bonds 2000
{{Bond market, state=collapsed
Bonds (finance)
Options (finance)
Embedded options