3.3.6.1. Callable Bonds
Callable bonds offer issuers the option to redeem the bonds prior to the maturity date. Why would an issuer want this? The answer has to do with interest rates.
When interest rates decline, issuers of callable bonds can lower their debt payments by redeeming their bonds (calling them) and then refinancing at a lower interest rate.
To compensate investors for the increased risk and to mitigate possible losses, callable bonds offer investors higher yields than non-callable bonds. Some callable bonds provide a call premium to lessen 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. For instance, 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. The trust indenture of a callable bond will include a call provision, which includes both the call date and the call price. The call provision will sometimes require an issuer to pay such a premium for early redemption. These provisions generally provide for lower premiums as the bonds approach their maturity date. 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. Callable bonds 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. 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.
A second type