How Callable (redeemable) Bonds Work

Summary:

Callable (or redeemable) bonds are a category of fixed-income security where the issuer has the option/right to buy them back (redeem) from the bondholders before their maturity. This blog goes into how they work.

Introduction to callable (or redeemable) bonds

Callable (or redeemable) bonds are a category of fixed-income security that is issued by corporations, governments and municipalities. The issuer of the bond has the option/right to buy them back (redeem) from the bondholders before their maturity. The issuer is able to exercise flexibility because of this feature but it also affects the attractiveness of the bond among investors. 

The following are some of the key features of callable bonds:

• Call date: These bonds come with a specific call date, typically mentioned in their terms and conditions. On these dates, the issuer can exercise the right to redeem them, usually at a price that is decided on. This is known as the call price or call premium.
• Call price: Usually, the call price is set at a premium to the bond's face value (par value). For instance, a redeemable bond with a face value of INR 1,000 can have a call price that is INR 1,080. This implies that when the issuer chooses to call the bond, he/she will need to pay INR 1,080 to the bondholders for each bond that they hold.
• Call protection period: These bonds usually have a call protection period. The issuer, during this period, will not be able to exercise the call option. This is done to provide assurance to bondholders so that they know they will earn interest until the expiration of the call protection period.
• Yield to call: Investors who put their money in callable bonds consider the ‘yield to call’ to be an addition to the yield to maturity (YTM). This represents the yield an investor would get if the issuer of the bonds calls for them on the call date that is earliest. The yield to maturity is relevant if the bond is not called.
• Reasons for calling bonds: Those who issue bonds may call them for many reasons, such as refinancing debt, taking advantage of a drop in interest rates, or eliminating some restrictions associated with the bonds.
• Risk for bondholders: These types of bonds are risky for bondholders. If there is a fall in the interest rate after the issuing of the bond, the person who issued it is likely to call the bond and have it refinanced at a rate that is lower. In such a scenario, bondholders are likely to get back their principal earlier than they expected and may have to choose to reinvest them at lower rates, which will reduce their returns.
• Benefits for issuers: These bonds provide flexibility to those who issue them. If the issuer's financial standing improves or the interest rates rise, they can choose to call the bonds. They can then issue new debt at an interest rate that is lower, thereby reducing their interest expenses.

Types of callable bonds

• Corporate callable bonds: These bonds are issued by corporations. They have the option to call them back before they mature. These are usually used to fund corporate activities and/or to refinance existing debt.
• Municipal callable bonds: Municipalities, such as those of towns, counties, cities and states usually issue these types of bonds to pay for public projects. These are also callable, because issuers may refinance debt and/or take advantage of interest rates that are lower.
• Government callable bonds: Government entities also issue callable bonds for funding public service projects.
• Step-up callable bonds: These have a call schedule with predetermined call dates and  call prices that keep on increasing. Here, the issuer can call the bonds at regular intervals. However, each time, the call price goes up. For the increasing risk, investors are entitled to higher yields.
• Make-whole callable bonds: These are often seen in corporate bonds. Rather than a certain call price, the issuer has to pay the bondholders a certain amount that will 'make them whole.' The amount usually depends on the current value of the bond's remaining cash flow, taking into account a benchmark interest rate plus a spread.
• Extendible callable bonds: These bonds give the issuer the ability to extend the maturity date of the bond if they choose not to call it. By exercising this, the issuer can delay repayment if they choose not to refinance on the call date.

An example:

Company XYZ issues a callable bond with the following details:

• Face value: INR 1,000
• Coupon rate: 4%
• Maturity date: 10 years from date of issuance 
• Call date: 5 years from date of issuance
• Call price: 105% of face value (INR 1,050 per bond)

There can be two outcomes:

Scenario 1: The bond is not called after the five-year call date:

• Bondholders will carry on receiving INR 40 in interest (annually) for the remaining five years.
• Bondholders will receive INR 1,000 at the end of the 10-year maturity period.

Scenario 2: The bond is called after the five-year call date:

• Bondholders will get the call price of INR 1,050 for each bond.
• They will no longer be entitled to interest payments and their bonds will have been redeemed.

Summing up:

The interest rate at the time and the issuers’ financial goal and strategy determine whether a bond will be called or not. Through these bonds, issuers get flexibility and introduce call risk for bondholders. This is because they will receive their principal earlier than planned if the issuer chooses to call the bond.