Callable Bonds
When interest rates go up, a company can retire its debt by buying its bonds in the open market at a lower price than principal. If trading volume is insufficient, the company might publish a tender offer, which is an offer to buy at a slight premium above the current market price to motivate bondholders to sell. Callable bonds come into play when interest rates go down. They come in several forms.
Optional calls allow the issuer to call the bond in whole or in part at its discretion for any reason. Generally a call option is exercised when the issuer can reissue the debt at a lower interest rate. What works for the issuer, of course, works against the creditor, who is forced to reinvest in the same lower yield environment.
But an issuer may exercise an optional call for other reasons in an interest rate environment that may not result in a loss for the investor. The company may wish to change the terms of the indenture, which might inconvenience the investor but not necessarily cause financial harm. Or the issuer may simply wish to reduce the amount of its debt.
Securities with optional redemption features come with higher yields than non-callable securities to compensate investors for their inconvenience and mitigate possible losses. Optional calls may also demand a call premium to mitigate the risk of a call. When a call price is set at a higher value than the face value of the bond, the difference is the call premium. A $1,000 bond with a call price of $1,100 has a $100 call premium payable to the investor if the bond is called. Another safeguard is call protection, which prohibits redemption during the first few years of the bond’s life. The earliest date on which a bond is callable is called the first call date.
A second type of call provision is the extraordinary call, in which a company may redeem its bond if certain events occur that are specified in the indenture, such as an earthquake or fire. These calls may be optional or