Callable Bonds: Understanding Issuer Redemption Rights

A callable bond (redeemable bond) is a type of bond that provides the issuer of the bond with the right, but not the obligation, to redeem the bond before its maturity date. The callable bond is a bond with an embedded call optionCall OptionA call option, commonly referred to as a "call," is a form of a derivatives contract that gives the call option buyer the right, but not the obligation, to buy a stock or other financial instrument at a specific price - the strike price of the option - within a specified time frame..

These bonds generally come with certain restrictions on the call option. For example, the bonds may not be able to be redeemed in a specified initial period of their lifespan. In addition, some bonds allow the redemption of the bonds only in the case of some extraordinary events.

Callable bonds may be beneficial to the bond issuers if interest ratesInterest RateAn interest rate refers to the amount charged by a lender to a borrower for any form of debt given, generally expressed as a percentage of the principal. are expected to fall. In such a case, the issuers may redeem their bonds and issue new bonds with lower coupon ratesCoupon RateA coupon rate is the amount of annual interest income paid to a bondholder, based on the face value of the bond..

On the other hand, callable bonds mean higher risk for investors. If the bonds are redeemed, the investors will lose some future interest payments (this is also known as refinancing risk). Due to the riskier nature of the bonds, they tend to come with a premium to compensate investors for the additional risk.

Generally, the majority of callable bonds are municipal or corporate bondsBond IssuersThere are different types of bond issuers. These bond issuers create bonds to borrow funds from bondholders, to be repaid at maturity..

How do callable bonds work?

To understand the mechanism of callable bonds, let’s consider the following example.

ABC Corp. issues bonds with a face value of $100 and a coupon rate of 6.5% while the current interest rate is 4%. The bonds will mature in 10 years.

However, the company issues the bonds with an embedded call option to redeem the bonds from investors after the first five years.

If interest rates have declined after five years, ABC Corp. may call back the bonds and refinance its debt with new bonds with a lower coupon rate. In such a case, the investors will receive the bond’s face value but will lose future coupon payments.

However, if the interest rate increases or remains the same, there is no incentive for the company to redeem the bonds and the embedded call option will expire unexercised.

How to find the value of a callable bond?

Valuing callable bonds differs from valuing regular bonds because of the embedded call option. The call option negatively affects the price of a bond because investors lose future coupon payments if the call option is exercised by the issuer.

The value of a callable bond can be found using the following formula:

Where:

• Price (Plain – Vanilla Bond) – the price of a plain-vanilla bond that shares similar features with the (callable) bond.
• Price (Call Option) – the price of a call option to redeem the bond before maturity.

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