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What Is a Callable Bond?

A callable bond is one that the borrower has the option to cancel before the maturity date. A callable bond favors the lender, because they are paid with a higher interest rate.

With these bonds, the lender sells it to you and then has the option to call it back before the maturity date. The issuing party may pay off their debt earlier and call its bond.

This is when the issuer of the bond pays out the investor, the call price (face value of bond), which at that point the issuer can stop paying interest to the investor.

How Do Callable Bonds Work? 

With callable bonds, the lender has the ability to refund the principal to the creditor and suspend interest payments prior to the bond’s maturity date. Bonds may be issued by businesses to finance growth or to repay any debts.

Bonds can be listed as callable if firms expect market interest rates to fall, allowing them to redeem the bond early.

Why Are Callable Bonds Useful?

With callable bonds, when existing interest rates fall below the bond’s interest rate, the issuer can opt to call the bond. By paying off the bond and selling a new bond at a reduced interest rate, the borrower saves money.

Callable bonds are riskier for borrowers than non-callable bonds since a callable bond requires the lender to invest the capital at a cheaper, less appealing cost.

How To Find the Value of Callable Bonds

Since callable bonds have an embedded call option, they are valued differently than standard bonds. The call option has a negative impact on a bond’s price because holders risk potential increases if the call option is exercised.

The formula to find the value of callable bonds is:

Price (Callable Bond) = Price (Plain-Vanilla Bond) – Price (Call Option).

Example of Callable Bonds

Imagine a bond with a maturity until 2040, is called in 2030. It could have a callable price of $104 which would mean for each $1,000 in face value of the fund, the lender would earn $1,040.

What Bonds Are Callable?

These would include most corporate and municipal bonds that are available to investors. Bonds like U.S. Treasury Notes and Treasury Bonds are not callable.

Sinking Fund

A sinking fund is a collection of funds put aside or borrowed for the purpose of repaying a loan or bond. This fund will have to be paid back later on by the business that issued the loans.

The sinking fund can be utilized to ease the pain of a high tax outlay. Businesses who have issued debt in the form of bonds may use a sunk fund to save money over time.

Callable bonds with sinking funds can be called back early, protecting the lender from any additional interest payments. A sinking fund can save a company money on interest and help keep them out of any financial trouble.

Call Protection

Many bonds have a clause called call protection that prevents the borrower from purchasing it back for a set amount of time. Call protection on callable corporate bonds typically would last around ten years.

What Bonds Are Non Callable?

A non-callable bond is one that is only paid out until it reaches its maturity date. Non-callable bonds are advantageous to investors because they ensure a fixed interest rate when the market is unpredictable.

Many U.S. Treasury Stocks and U.S. Treasury Bonds would be considered non callable.

Connection Between Interest Rates and Callable Bonds

A callable bond is usually called at a price that is marginally higher than the debt’s par value. The higher the call date of a bond, the earlier in its life cycle it is named.

If interest rates are expected to decline, callable bonds can be useful to bond issuers. Issuers can choose to repay their bonds and replace them with new bonds with lower coupon rates in order to earn a net profit.

Advantages of Callable Bonds

The issuer of callable bonds has the option to redeem bonds issued early. In exchange, the buyer would receive a bond with a higher coupon rate.

They normally pay a higher coupon rate than other bonds which can be very beneficial to the buyer. Corporations that issue callable bonds can pay off the bonds and reissue them to the public at cheaper cost if interest rates decline.

Disadvantages of Callable Bonds

If an investor is unable to reinvest the returns created by an investment, they can be exposed to reinvestment risk. Another drawback for utilizing callable bonds is that if the lender calls the loan, the investor would have to reinvest at a lower pace.

Callable vs Putable Bonds

A put bond is a debt contract with an inserted option that allows bondholders to request to be repaid the principal earlier. When the bond matures, the owners or lenders will earn their principal investment, which is priced at par.

Putable bonds give bondholders greater leverage over the result of the investment. Their bond indenture specifies the conditions in which a bondholder can redeem or return the bonds.

With putable bonds, if interest rates increase this would reduce existing bond premiums and the bondholder would have the option to sell the bond back to the borrower and potentially earn a profit.

Also, putable bonds are often more expensive than callable bonds without a put provision, and provide a lower yield.

Financial Advisors Can Help You Invest in Bonds

A callable bond is one that the borrower has the option to call before the maturity date. With callable bonds the lender has the ability to refund the principal to the creditor and suspend interest payments prior to the bond’s maturity date.

Bonds may be issued by businesses to finance growth or to repay any debts.

Financial advisors can help analyze your money and invest in different types of bonds that you can potentially benefit from. You should consider contacting a financial advisor to help you manage your money and make investments.