What it means
Many bonds include a call provision, which gives the issuer the right to repay the bond before its due date. Issuers use it when interest rates fall, so they can repay expensive debt and borrow again more cheaply.
A non-callable bond does not include this right. For the investor, this is a valuable protection.
The bond will keep paying the same interest until maturity, so the investor does not face the risk of having the bond taken away just when rates have dropped. Without that protection, the investor would have to reinvest the returned money at lower rates.
Some bonds are only partly protected. They may be non-callable for an initial period, for example the first five years of a ten-year bond, and callable afterwards.
This feature is often described as call protection, and the investor should check exactly how long it lasts. Because the investor gives up nothing, non-callable bonds usually offer lower yields than similar callable bonds.
The callable bond pays extra to compensate for the chance of early repayment. The difference in yield is, in effect, the price of the issuer's option.
For issuers, the trade-off is flexibility. A company that issues a non-callable bond locks in its interest cost, which is helpful if rates rise but costly if rates fall and it cannot refinance.
Treasurers often choose non-callable debt when they value certainty of cost or when investors demand it. Pension funds, insurers and other long-term investors tend to like non-callable bonds because they need predictable cash flows to match future obligations.
A bond that might disappear early makes planning harder. For them, the certainty is often worth the lower yield.
In practice
Real-world examples.
Example
A pension fund buys a 20-year non-callable government bond to match payments it will make to retirees. The fund knows exactly how much interest it will receive each year. If the issuer could call the bond early, the fund would face the risk of reinvesting at lower rates. The fund accepts a slightly lower yield in return for that certainty.
Example
A utility company issues a 15-year non-callable bond at 5.5% because investors prefer the certainty. If market rates fall to 4%, the company cannot repay the bond early and continues to pay 5.5%. The treasurer accepts this as the price of attracting investors. The company's annual report explains that the lack of early repayment rights is a deliberate choice.
Example
A retail investor compares two bonds from the same company, one callable and one non-callable. The callable bond offers 6.2% while the non-callable bond offers 5.8%. She chooses the non-callable bond because she wants a stable income for her retirement. She notes that the extra 0.4% from the callable bond would not compensate her for the chance of losing the investment early.
Formula
Calculation
Total interest to maturity = face value x coupon rate x years to maturity
An investor buys a non-callable bond with a $100,000 face value, a 5% coupon and 10 years to maturity. Annual interest = 100,000 x 0.05 = $5,000, so total interest over 10 years = 5,000 x 10 = $50,000. Because the bond cannot be called, the investor can rely on receiving all $50,000, plus the $100,000 principal at maturity.Case study
Seen in the real world.
Stonebridge Utilities is a fictional company that issued $50,000,000 of non-callable bonds at 5% for twelve years. In this illustrative story, market interest rates fell to 3% four years later. Competitors with callable bonds repaid them and refinanced at lower rates.
Stonebridge could not do the same and continued to pay $2,500,000 in annual interest. Its chief financial officer admitted that the cost was higher than a refinancing would have been, but she noted that investors had paid a premium price for the bond because of its protection. The company decided to issue callable bonds in future when its forecasts showed rates were likely to fall.
After the episode, Stonebridge's treasurer built a simple rule into the company's debt policy. For each new bond, the finance team compares the extra yield investors demand for a callable structure with the likely saving from calling it, using three interest rate scenarios. The comparison now forms part of the board paper for every borrowing decision, and the board has found that it focuses discussion on the real cost of flexibility.
Watch out
Common mistakes.
- Assuming non-callable means no risk. The bond still carries credit risk, interest rate risk and inflation risk.
- Ignoring partial call protection. Some bonds can be called after an initial period, so read the terms.
- Thinking the issuer can never redeem the bond. It may be able to buy it back in the open market or in a tender offer.
Questions
People also ask.
What does non-callable mean?
The issuer cannot force investors to hand back the bond before it matures.
Why do non-callable bonds yield less?
Because the investor is not taking on the risk of early repayment, so less compensation is needed. The gap in yield between the two types is the market's price for the issuer's right to call.
Who benefits from a non-callable bond?
Investors who want predictable income for a known period, such as pension funds and insurers. They can plan ahead knowing the payments will arrive as scheduled.
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