Series 7: 2.11.1. Callable Bonds

2.11.1. Callable Bonds

With callable bonds, the issuer has the option to redeem or call specific bonds prior to the stated maturity date. Callable bonds come in several forms.

Optional calls allow the issuer to call the bond in whole or in part at its discretion for any reason. Generally, a call option is exercised when the issuer can reissue the debt at a lower interest rate. What works in favor of the issuer, of course, works against the bondholder, who is forced to reinvest in the same lower yield environment.

An issuer also may exercise an optional call in an interest rate environment that may not result in a loss for the investor. The company may wish to change the terms of the indenture, which might inconvenience the investor but not necessarily cause financial harm. Or the issuer may simply wish to reduce the amount of its debt.

Securities with optional redemption features come with higher yields than non-callable securities to compensate investors for the increased risk and mitigate possible losses. Optional calls may also demand a call premium to lessen the risk of a call. When a call price is set at a higher value than the face value of the bond, the difference is the call premium. A $1,000 bond with a call price of $1,100 has a $100 call premium payable to the investor if the bond is called. Call provisions sometimes require an issuer to pay a premium for early redemption. Such provisions generally provide for lower premiums as the bonds approach their maturity date. Another safeguard is call protection, which prohibits redemption during the first few years of the bond’s life. The earliest date on which a bond is callable is known as the first call date.

The second type of callable bond is the extraordinary call, in which a company may redeem its bond if certain events occur that are specified in the indenture,