Typically, you will see bond prices increase as interest rates decrease. This phenomenon is called price compression, and it is an integral aspect of how callable bonds behave. After five years, if ICICI Bank chooses to exercise the call option, it can redeem the bonds at the call price of INR 1,050. As an investor, you will receive the face value of INR 1,000 plus the accrued interest up to the call date. However, your future interest payments will cease if the bonds are called back.
This option provides the issuer with the ability to “call back” or retire the bond after a designated call date, often at a specified call price. However, issuers are likely to exercise a call provision after interest rates have fallen. When that happens, they can pay back the principal of existing bonds, then issue new ones at lower interest rates.
Should this happen, you would have benefited in the short term from a higher interest rate. However, you would then have to reinvest your assets at the lower prevailing rates. Higher risks usually mean higher rewards in investing, and callable bonds are another example of that phenomenon. Callable bonds function like traditional bonds, but with an embedded call option for the issuer. Suppose you buy a bond from Company XYZ that has a 10-year maturity date and pays a 6% annual coupon. The bond’s face value is $1,000, which means Company XYZ agrees to repay you $1,000 when the bond matures in 10 years.
Are Callable Bonds a Good Addition to a Portfolio?
Due to the latent risk of this security type, investors also enjoy a higher income than holders of standard bonds. There can be two ways of compensation, as mentioned above, i.e. either a higher coupon rate or redemption at a premium. If you do not fully understand callable bonds and call features, callable bond meaning simply avoid callable bonds. If you do avoid callable bonds, you will have a tough time finding municipal bonds with maturities beyond 10 years.
Callable (or Redeemable) Bond Types, Example, Pros & Cons
- However, locating bonds without call features might not be easy, as the vast majority tend to be callable.
- This price means the investor receives $1,020 for each $1,000 in face value of their investment.
- Bonds can be sometimes referred to as trading above or below their par value.
A callable bond allows the issuing company to pay off their debt early. A business may choose to call their bond if market interest rates move lower, which will allow them to re-borrow at a more beneficial rate. Callable bonds thus compensate investors for that potentiality as they typically offer a more attractive interest rate or coupon rate due to their callable nature.
Disadvantages of callable bonds
- In relation to the purchase price of $1,200, you will have lost $100 in the transaction of buying and selling.
- A callable bond is a bond that can be redeemed by the issuer before its maturity date at a predetermined call price.
- Here, the premium rate at which an issuer calls the bonds depends on the period left to its maturity.
When callable bonds are redeemed, investors may need to shift to a low-income debenture or assume higher risk by investing in stocks. A municipal bond has call features that may be exercised after a set time period such as ten years. Effective tactical use of callable bonds depends on one’s view of future interest rates. Keep in mind that a callable bond is composed of two primary components, a standard bond and an embedded call option on interest rates.
However, there’s uncertainty on the part of an investor regarding whether they’ll continue to earn interest till maturity. Since the issuer possesses the right and not an obligation to exercise the call option, it might not redeem the securities before the maturity date. Organisations usually issue these bonds when there’s a sign of interest rates moving downwards in the future.
Also, many corporations see their credit ratings tumble during difficult times. Corporations whose creditworthiness took a hit likely issued callable bonds in hopes of improving their creditworthiness and eventually issuing new debt at a lower rate. Some benefits of investing in bonds include diversification, fixed income, and return on principal if held to maturity date. Some risks of investing in bonds are interest rate risk, inflation, and credit risk.
Finally, you can employ certain bond strategies to help protect your portfolio from call risk. Laddering, for example, is the practice of buying bonds with different maturity dates. If you have a laddered portfolio and some of your bonds are called, your other bonds with many years left until maturity may still be new enough to be under call protection. And your bonds nearer maturity won’t be called, because the costs of calling the issue wouldn’t be worth it for the company. While only some bonds are at risk of being called, your overall portfolio remains stable. At such a time, you as a bondholder should examine your portfolio to prepare for the possibility of losing that high-yielding asset.
Registration granted by SEBI and certification of NISM is no way guarantee performance of the intermediary or provide any assurance of returns to investors. There are several different types of callable bonds that vary based on when the issuer is allowed to redeem the bond. Just as you might want to refinance your 6% mortgage if interest rates dropped to 3%, Company XYZ will want to refinance its debt to save money on interest. Generally, the majority of callable bonds are municipal or corporate bonds.
A callable bond is a debt instrument in which the issuer reserves the right to return the investor’s principal and stop interest payments before the bond’s maturity date. Corporations may issue bonds to fund expansion or to pay off other loans. If they expect market interest rates to fall, they may issue the bond as callable, allowing them to make an early redemption and secure other financings at a lowered rate. The bond’s offering will specify the terms of when the company may recall the note. There is no free lunch, and the higher interest payments received for a callable bond come at the cost of reinvestment-rate risk and diminished price-appreciation potential. That makes callable bonds one of many tools for investors to express their tactical views on financial markets and achieve an optimal asset allocation.
Interest Rates and Callable Bonds
Please consult a tax professional or refer to the latest regulations for up-to-date information. The Reserve Bank of India (RBI) governs such issuances, particularly for banks and financial institutions. Get stock recommendations, portfolio guidance, and more from The Motley Fool’s premium services.
Illustrated History of Every Bear Market
If market interest rates decline after a corporation floats a bond, the company can issue new debt, receiving a lower interest rate than the original callable bond. The company uses the proceeds from the second, lower-rate issue to pay off the earlier callable bond by exercising the call feature. As a result, the company has refinanced its debt by paying off the higher-yielding callable bonds with the newly-issued debt at a lower interest rate. As we mentioned above, the main reason a bond is called is a drop in interest rates.
You would be misinformed to think only corporate bonds can be called. The main factor that causes an issuer to call its bonds is interest rates. One feature, however, that you want to look for in a callable bond is call protection. This means there’s a period during which the bond cannot be called, allowing you to enjoy the coupons regardless of interest rate movements.
If the bond is called early, you are “gaining” the $500 back over 6 years rather than waiting for the full 13 years. Call protection refers to the time period when the bond cannot be called. The issuer must clarify whether a bond is callable and the exact terms of the call option, including when the timeframe as to when the bond can be called. Conversely, your bond will appreciate less in value than a standard bond if rates fall and might even be called away.
In the U.S., mortgages are usually fixed rate, and can be prepaid early without cost, in contrast to the norms in other countries. By issuing numerous callable bonds, they have a natural hedge, as they can then call their own issues and refinance at a lower rate. 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.
What are bonds and how do they work?
Since call features are considered a disadvantage to the investor, callable bonds with longer maturities usually pay a rate at least a quarter-point higher than comparable non-callable issues. Call features can be found in corporate, municipal and government issues as well as CDs. In recent years, investment in securities has gained tremendous ground among laypersons. This positive development in investor confidence can be attributed to newer, coming-of-age digital platforms making investments easier. Options like mutual funds are gaining currency rapidly, allowing individuals to utilise their excess income in financially fruitful ways. However, the financial market features a vast array of securities, like a callable bond.