How do callable bonds work

Callable bonds give issuers the right to effectively refinance their debt later at a better rate, just as a homeowner might do by refinancing his or her mortgage. If rates have declined from the time the company or city first issued the bond, the issuer may want to refinance its debt at a lower interest rate. After calling its current bonds , the issuer can then reissue them at a lower interest rate.

The earlier a bond is called, the more its value increases, since the bond can be called just above the par value.

Unlike a noncallable bond, a callable bond pays a higher coupon to an investor. In this era of low interest rates , callable bonds by companies and cities have gained in popularity. To be sure, the impact of a bond being called can be significant, especially if an investor had mistakenly factored it in as fixed income.

That person is left with a gap in anticipated income. The Sharp Razor Co. In this example, Sharp Razor has an option to redeem the bonds from investors before the bonds mature on Oct. Callable bonds are more risky for investors than non-callable bonds because an investor whose bond has been called is often faced with reinvesting the money at a lower, less attractive rate.

As a result, callable bonds often have a higher annual return to compensate for the risk that the bonds might be called early. Learn more here , here , here and here. Test your knowledge on common investing terms and strategies and current investing topics. Learn about investing risks in certain companies that provide exposure to China-based businesses.

Are you prepared for your financial future? Use this checklist to get started. Please enter some keywords to search. Breadcrumb Home Introduction to Investing Glossary. When interest rates go down, borrowing becomes cheaper. If it is now cheaper to borrow the corporation would rather pay the lower rate of interest by retiring old bonds and issuing new bonds at the current lower rate.

Not necessarily. When a company issues a new bond offering there are cost involved. There is an underwriting process, legal documents have to be drafted, and brokers have to be compensated for getting the bonds out to investors. Before a bond is called, the company or municipality since many municipal bonds are callable has to be sure that the interest savings on the new issue would be enough to cover all those expenses.

Some bond issues are structured so that a portion of the bonds are called periodically before maturity. The indenture may contain a sinking fund provision that stipulates money is set aside to purchase some of the bonds each year. This is actually a safety feature because it prevents the company from having to retire the entire issue at once when it matures. Those bonds will mature in 10 years.

The issuer will then return your principal along with any unpaid accrued interest and the call premium. If the bond contains a call provision it will also explicitly state the call premium.

The call premium is an extra amount above the maturity value that the company must pay in order to call a bond before maturity. There are several ways to measure the return on bonds. You can use my bond price calculator to help you calculate them for any bond.

The two most important in most cases are the yield to maturity and the current yield. The current yield is simply the coupon payment as a percentage of the bonds price.

It lets you know what rate you are getting on the current value of the bond.