What it means
A bond is normally a fixed commitment: the issuer pays the coupon for the life of the bond and repays the principal at maturity, and the investor can rely on that schedule. A call provision changes the commitment on one side.
The issuer keeps the option to end the bond early, while the investor has no equivalent right. The issuer wants that option for the same reason a homeowner wants to be able to refinance a mortgage.
If a company issues a ten-year bond at 7% and rates fall to 5% three years later, it is paying two points more than it needs to on every dollar. With a call, it can redeem the 7% bond and issue a new one at 5%.
Without it, it is locked in. Companies also call bonds when they have surplus cash, when they are restructuring their debt, or when a covenant in the bond has become inconvenient.
The terms of the call are set at issue. Most callable bonds have a call protection period, often the first three to five years, during which they cannot be called.
After that, they may be callable at any time (a continuous call) or on specific dates such as coupon dates. The call price often starts at a premium to face value (102 or 103, meaning $1,020 or $1,030 per $1,000) and declines to par over subsequent years, compensating the investor for early loss of the bond.
Some bonds instead have a make-whole call, under which the issuer must pay the present value of the remaining payments discounted at a low rate, which makes the call expensive and rarely used except in restructurings. The investor's position is asymmetric.
If rates rise, the bond falls in price like any other and the issuer does not call it, so the investor is stuck with a below-market coupon. If rates fall, the bond's price rises only until it approaches the call price, because nobody will pay much more than the issuer can redeem it for; then the issuer calls it and the investor must reinvest at the new lower rates.
The investor has sold the issuer an option and is paid for it through a higher coupon, a lower issue price, or both. Analysis therefore looks at several yields.
Yield to maturity assumes the bond runs to the end. Yield to call assumes it is called at the first (or a specified) call date at the call price.
Yield to worst is the lowest of the yields across all possible call dates and maturity, and is the conservative figure an investor should assume. When a callable bond trades above its call price, yield to call is usually below yield to maturity, and the market prices the bond as if it will be called.
From the issuer's side, the call is accounted for as part of the bond's terms; when the bond is called, any unamortised issue costs and any premium paid are recognised as a loss on extinguishment, offset over time by the lower interest on the replacement debt.
In practice
Real-world examples.
Example
A utility issues 30-year bonds callable after 10 years at 104, declining to par by year 20, giving it flexibility to refinance if rates fall.
Example
A bank's subordinated bonds are callable after five years and the market expects the call, so they trade as five-year paper.
Example
A government agency's callable mortgage bonds are called in a falling-rate year, forcing pension fund holders to reinvest at lower yields.
Think of it
“A callable bond can be paid off early by the issuer-usually when interest rates fall.
Formula
Calculation
Yield to Call: the discount rate at which the present value of coupons to the call date plus the call price equals the current bond price
Yield to Worst = Minimum of yield to maturity and yield to each call date
Refinancing Saving = (Old coupon minus New coupon) x Principal x Remaining years minus Call premium minus New issue costs
Worked example, the issuer. A company has $50,000,000 of 7% bonds outstanding with six years to maturity, callable now at 102. Market rates for its credit are 5%. New issue costs would be 1% of principal.
- Call premium = 2% x $50,000,000 = $1,000,000
- Issue costs on replacement bonds = $500,000
- Annual interest saving = (7% minus 5%) x $50,000,000 = $1,000,000
- Six-year saving = $6,000,000, less costs of $1,500,000 = net $4,500,000 before discounting
- Present value of the saving at 5% = $1,000,000 x 5.076 = $5,076,000; less $1,500,000 = $3,576,000 net present value. The company calls the bonds.
Worked example, the investor. The same bond, bought at issue for $1,000 with a 7% coupon, is now priced at $1,025 with six years to maturity and callable at $1,020 in one year.
- Yield to maturity (holding to year six): the rate at which $70 a year for six years plus $1,000 discounts to $1,025 is about 6.5%
- Yield to call (called in one year at $1,020): the investor receives $70 plus $1,020 = $1,090 in one year on $1,025 paid, a return of 6.3%
- Yield to worst = 6.3%
- Compared with a non-callable bond of the same issuer yielding 5%, the callable bond's higher yield is the payment for the call risk; but the investor should expect to receive the 6.3%, not the 6.5%, and to face reinvestment at 5% next year.Case study
Seen in the real world.
A hospital group financed a new building with $120,000,000 of 25-year bonds at 6.25%, callable after ten years at 101. In year eleven, rates for comparable borrowers had fallen to 4%. The treasurer proposed calling the bonds and refinancing with a new 15-year issue.
The board's finance committee asked for the full arithmetic: call premium $1,200,000; new issue costs $1,400,000; annual interest saving (6.25% minus 4%) x $120,000,000 = $2,700,000; present value of that saving over 15 years at 4% = $2,700,000 x 11.118 = $30,019,000; net present value of the refinancing about $27,400,000. The committee also asked what the bondholders would experience: the bonds had been trading at 108, and holders would receive 101, losing seven points of market value they had never really owned, because the price had been capped by the call all along.
One committee member asked why the group had not issued non-callable bonds at a lower coupon in the first place; the treasurer's answer was that the callable structure had cost about 0.35% a year for ten years ($4,200,000) and had just returned $27,000,000, which was the option working exactly as intended. The group called the bonds, and the finance committee adopted a policy of reviewing every callable issue for refinancing whenever rates fell more than one point below the coupon.
Watch out
Common mistakes.
- Valuing a callable bond on its yield to maturity when it trades above the call price. The market expects the call; use yield to worst.
- An investor treating the higher coupon as free extra return rather than as payment for an option the issuer will exercise when it hurts most.
- An issuer failing to review outstanding callable debt when rates fall, leaving refinancing savings unclaimed.
Questions
People also ask.
Why would an investor buy a callable bond?
For the higher coupon, and where the investor's view is that rates will not fall enough to trigger the call.
What is a make-whole call?
A call at a price equal to the present value of remaining payments discounted at a low rate (often a government yield plus a small spread), which compensates the investor fully and makes the call expensive for the issuer.
What is the opposite of a callable bond?
A puttable bond, which gives the investor the right to sell it back to the issuer early, typically when rates have risen.
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