Callable bond
Encyclopedia
A callable bond is a type of bond
(debt security
) that allows the issuer
of the bond to retain the privilege of redeeming the bond at some point before the bond reaches the date of maturity. In other words, on the call date(s), the issuer has the right, but not the obligation, to buy back the bonds from the bond holders at a defined call price. Technically speaking, the bonds are not really bought and held by the issuer but are instead cancelled immediately.
The call price will usually exceed the par
or issue price. In certain cases, mainly in the high-yield debt
market, there can be a substantial call premium.
Thus, the issuer has an option
, for which it pays in the form of a higher coupon
rate. If interest rates in the market have gone down by the time of the call date, the issuer will be able to refinance its debt at a cheaper level and so will be incentivized to call the bonds it originally issued. Another way to look at this interplay is that as interest rates go down, the price of the bonds goes up. Therefore, it is advantageous to buy the bonds back at par value
.
With a callable bond, investors have the benefit of a higher coupon
than they would have had with a straight, non-callable bond. On the other hand, if interest rates fall, the bonds will likely be called, and they can only invest at the lower rate. This is comparable to selling (writing) an option—the option writer gets a premium up front, but has a downside if the option is exercised.
The largest market for callable bonds is that of issues from government sponsored entities. They own a lot of mortgages and mortgage-backed securities
. In the U.S. mortgages are usually fixed rate, and can be prepaid early without cost, contrary to other countries. If rates go down, a lot of home owners will refinance at a lower rate. This means that the agencies lose assets. By issuing a large number of callable bonds, they have a natural hedge, as they can then call their own issues and refinance at a lower rate.
The price behaviour of a callable bond is the opposite of that of puttable bond
. Since call option
and put option
are not mutually exclusive
, a bond may have both options embedded.
Bond (finance)
In finance, a bond is a debt security, in which the authorized issuer owes the holders a debt and, depending on the terms of the bond, is obliged to pay interest to use and/or to repay the principal at a later date, termed maturity...
(debt security
Security
Security is the degree of protection against danger, damage, loss, and crime. Security as a form of protection are structures and processes that provide or improve security as a condition. The Institute for Security and Open Methodologies in the OSSTMM 3 defines security as "a form of protection...
) that allows the issuer
Issuer
Issuer is a legal entity that develops, registers and sells securities for the purpose of financing its operations.Issuers may be domestic or foreign governments, corporations or investment trusts...
of the bond to retain the privilege of redeeming the bond at some point before the bond reaches the date of maturity. In other words, on the call date(s), the issuer has the right, but not the obligation, to buy back the bonds from the bond holders at a defined call price. Technically speaking, the bonds are not really bought and held by the issuer but are instead cancelled immediately.
The call price will usually exceed the par
Par value
Par value, in finance and accounting, means stated value or face value. From this comes the expressions at par , over par and under par ....
or issue price. In certain cases, mainly in the high-yield debt
High-yield debt
In finance, a high-yield bond is a bond that is rated below investment grade...
market, there can be a substantial call premium.
Thus, the issuer has an option
Option (finance)
In finance, an option is a derivative financial instrument that specifies a contract between two parties for a future transaction on an asset at a reference price. The buyer of the option gains the right, but not the obligation, to engage in that transaction, while the seller incurs the...
, for which it pays in the form of a higher coupon
Coupon (bond)
A coupon payment on a bond is a periodic interest payment that the bondholder receives during the time between when the bond is issued and when it matures. Coupons are normally described in terms of the coupon rate, which is calculated by adding the total amount of coupons paid per year and...
rate. If interest rates in the market have gone down by the time of the call date, the issuer will be able to refinance its debt at a cheaper level and so will be incentivized to call the bonds it originally issued. Another way to look at this interplay is that as interest rates go down, the price of the bonds goes up. Therefore, it is advantageous to buy the bonds back at par value
Par value
Par value, in finance and accounting, means stated value or face value. From this comes the expressions at par , over par and under par ....
.
With a callable bond, investors have the benefit of a higher coupon
Coupon (bond)
A coupon payment on a bond is a periodic interest payment that the bondholder receives during the time between when the bond is issued and when it matures. Coupons are normally described in terms of the coupon rate, which is calculated by adding the total amount of coupons paid per year and...
than they would have had with a straight, non-callable bond. On the other hand, if interest rates fall, the bonds will likely be called, and they can only invest at the lower rate. This is comparable to selling (writing) an option—the option writer gets a premium up front, but has a downside if the option is exercised.
The largest market for callable bonds is that of issues from government sponsored entities. They own a lot of mortgages and mortgage-backed securities
Mortgage-backed security
A mortgage-backed security is an asset-backed security that represents a claim on the cash flows from mortgage loans through a process known as securitization.-Securitization:...
. In the U.S. mortgages are usually fixed rate, and can be prepaid early without cost, contrary to other countries. If rates go down, a lot of home owners will refinance at a lower rate. This means that the agencies lose assets. By issuing a large number of callable bonds, they have a natural hedge, as they can then call their own issues and refinance at a lower rate.
The price behaviour of a callable bond is the opposite of that of puttable bond
Puttable bond
Puttable bond is a bond with an embedded put option. The holder of the puttable bond has the right, but not the obligation, to demand early repayment of the principal...
. Since call option
Call option
A call option, often simply labeled a "call", is a financial contract between two parties, the buyer and the seller of this type of option. The buyer of the call option has the right, but not the obligation to buy an agreed quantity of a particular commodity or financial instrument from the seller...
and put option
Put option
A put or put option is a contract between two parties to exchange an asset, the underlying, at a specified price, the strike, by a predetermined date, the expiry or maturity...
are not mutually exclusive
Mutually exclusive
In layman's terms, two events are mutually exclusive if they cannot occur at the same time. An example is tossing a coin once, which can result in either heads or tails, but not both....
, a bond may have both options embedded.
Pricing
Price of callable bond = Price of straight bond – Price of call option;- Price of a callable bond is always lower than the price of a straight bond because the call option adds value to an issuer;
- Yield on a callable bond is higher than the yield on a straight bond.