A callable bond, also known as a redeemable bond, is a bond that the issuer may redeem before it reaches the stated maturity date. A callable bond allows the issuing company to pay off their debt early.
A business may choose to call their bond if market interest rates move lower, which will allow them to re-borrow at a more beneficial rate. Callable bonds thus compensate investors for that potentiality as they typically offer a more attractive interest rate or coupon rate due to their callable nature. Key Takeaways A callable bond is a debt security that can be redeemed early by the issuer before its maturity at the issuer's discretion.
A callable bond allows companies to pay off their debt early and benefit from favorable interest rate drops. A callable bond benefits the issuer, and so investors of these bonds are compensated with a more attractive interest rate than on otherwise similar non-callable bonds.
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Corporations may issue bonds to fund call option bonds or to pay call option bonds other loans. If they expect market interest rates to fall, they may issue the bond as callable, allowing them to make an early redemption and secure other financings at a lowered rate. The bond's offering will specify the terms of when the company may recall the note. A callable—redeemable—bond is typically called at a value that is slightly above the par value of the debt.
The earlier in a bond's life span that it is called, the higher its call value will be. For example, a bond maturing in can be called in It may show a callable price of The bond may also stipulate that the early call price goes down to after a year. Types of Callable Bonds Callable bonds come with many variations. Optional redemption lets an issuer redeem its bonds according to the terms when the bond was issued.
This is an exit route for investors who may be looking to move out of their bond investments.
However, not all bonds are callable. Treasury bonds and Treasury notes are non-callable, although there are a few exceptions. Most municipal bonds and some corporate bonds are callable. A municipal bond has call features that may be exercised after a set period such as 10 years.
Sinking fund redemption requires the issuer to adhere to a set schedule while redeeming a portion or all of its debt.
On specified dates, the company will remit a portion of the bond to bondholders. Call option bonds sinking fund helps the company save money over time and avoid a large lump-sum payment at maturity.
A sinking fund has bonds issued whereby some of them are callable for the company to pay off its debt early.
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Extraordinary redemption lets the issuer call call option bonds bonds before maturity if specific events occur, such as if the underlying funded project is damaged or destroyed. Call protection refers to the period when the bond cannot be called. The issuer must clarify whether a bond is callable and the exact terms of the call option, including when the timeframe when the bond can be called. Callable Bonds and Interest Rates If market interest rates decline after a corporation floats a bond, the company can issue new debt, receiving a lower interest rate than the original callable bond.
The company uses the proceeds from the second, lower-rate issue to pay off the earlier callable bond by exercising the call feature.
As a result, the company has refinanced its debt by paying off the higher-yielding callable bonds with the newly-issued debt at a lower interest rate.
Paying down debt early by exercising callable bonds saves a company interest expense and prevents the company from being put in financial difficulties in the long term if economic or financial conditions worsen. However, the investor might not make out as well as the company when the bond is called.
The bondholder must turn in the bond to get back the principal, and no further interest is paid.
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This situation is known as reinvestment risk. The investor might choose to reinvest at a lower interest rate and lose potential income. Also, if the investor wants to purchase another bond, the new bond's price could be higher than the price of the original callable. In other words, the investor might pay a higher price for a lower yield.
As a result, a callable bond may not be appropriate for investors seeking stable income and predictable returns. Advantages and Disadvantages of Callable Bonds Callable bonds typically pay a higher coupon or interest rate to investors than non-callable bonds.
Best binary options trading companies that issue these products benefit as well. Should the market interest rate fall lower than the rate being paid to the bondholders, the business may call the note.
They may then, refinance the debt at a lower interest rate. This flexibility is usually more favorable for the business than using bank-based lending. However, not every aspect of a callable bond is favorable.
An issuer will usually call the bond when interest rates fall. This calling leaves the investor exposed to replacing the investment at a rate that will not return the same level of income.
Conversely, when market rates rise, the investor can fall behind when their funds are tied up in a product that pays a lower rate.
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Finally, companies must offer a higher coupon to attract investors. This higher coupon will increase the overall cost of taking on new projects or expansions. Pros Pay a higher coupon or interest rate Investor-financed debt is more flexibility for the issuer Helps companies raise capital Call features allow recall and refinancing of debt Cons Investors must replace called bonds with lower rate products Investors cannot take advantage when market rates rise Coupon rates are higher raising the costs to the company Example of a Callable Bond Let's say Apple Inc.