Bonds that can be redeemed or paid off by the issuer before their maturity date are known as callable or redeemable bonds. When an issuer calls its bonds, it pays investors the call price (typically the face value of the bonds) plus any accrued interest up to that point, and then stops paying interest. A call premium is sometimes charged as well. Corporate and municipal bonds frequently include call provisions.
When current interest rates fall below the bond’s interest rate, the issuer may choose to call the bond. By paying off the bond and issuing a new bond with a reduced interest rate, the issuer saves money. This is akin to refinancing your home’s mortgage to lessen your monthly payments. Callable bonds are riskier for investors than non-callable bonds since a callable bond requires the investor to reinvest the money at a lower, less appealing rate. As a result, callable bonds frequently provide a greater annual return to compensate for the risk of early redemption.
- Redemption is an option. Allows the issuer to redeem the bonds at any time. Many municipal bonds, for example, contain optional call features that issuers can activate after a set period of time, often ten years.
- Redemption from a Sinking Fund. Requires the issuer to repay a specific percentage or all of the bonds on a regular basis, according to a set schedule.
- Redemption of the highest kind. Allows the issuer to call its bonds before they mature if specific conditions are met, such as the project for which the bond was issued being damaged or destroyed.
What is the most likely bond name?
When is it probable that a bond will be called? A callable bond is likely to be called if current interest rates are significantly below its coupon rate, and investors will evaluate its most likely rate of return as the yield to call rather than the yield to maturity.
Why do callable bonds exist?
Companies Issue Callable Bonds for a variety of reasons. Companies issue callable bonds to take advantage of potential interest rate reductions. According to the bond’s terms, the issuing corporation can redeem callable bonds before the maturity date.
Which of the following situations would increase the likelihood of a corporation calling its callable bonds?
The right response is c. Market interest rates are rapidly declining. When interest rates fall sharply, the corporation prefers to recall as many binds as possible.
What is a bond issue’s call feature?
A bond’s call feature gives the issuer the authority to require bondholders to sell their bonds for the call price. For corporate and municipal government bonds, call features are commonly employed.
When a bond is called, the call price is the amount paid to bondholders. It’s on par with or better than par. The call price is frequently set at par plus one year’s interest. The call price falls near par when the bond matures (see Figure 12.1). The bond indenture specifies the exact terms and dates.
In recent years, callable corporate bonds have had a call protection period following their initial issuance. The bond cannot be called and replaced by another bond during the call-protected period. Most bonds, however, can be called for reasons other than replacement with a lower-cost bond – these are known as redemptions. Even during the call protection period, bonds can be redeemed and replaced with stock.
The percentage of corporate bonds with call options has fluctuated throughout time. The vast majority of bonds have featured call features at points. Previously, the vast majority of bonds were noncallable. When interest rates were high, the proportion of callable bonds appeared to be high, and when interest rates were low, the proportion of callable bonds appeared to be low.
What exactly is risk?
The danger that a bond issuer would redeem a callable bond before it matures is known as call risk. This means that the bondholder will be paid the bond’s face value and will most likely be reinvesting in a less favorable environment—one with a lower interest rate.
What is the term for bond protection?
Some bonds have a clause called call protection that prevents the issuer from buying it back for a set length of time. When interest rates in the economy as a whole decline, bonds are often called. For a defined amount of time, call protection precludes the issuer from repurchasing it.
What is a term bond, exactly?
A term bond is one that has a single, definite maturity date in the future. The face value of the bond (i.e., the principal amount) must be repaid to the bondholder at the moment. The term of a bond refers to the time between when it is issued and when it matures.
Should companies issue revocable bonds?
Companies issue callable bonds rather than non-callable bonds to protect themselves in the event that interest rates fall. For example, if a firm issues callable bonds that pay investors the current rate of interest of 7% yearly and the going rate drops to 6%, the corporation may redeem the callable bonds and replace them with new bonds earning 6% annually.
This is especially important for bonds with maturities of 20 years or more. Without callability, a corporation could issue bonds with a high interest rate that it won’t be able to adjust for 20 years. At a time when fresh bonds are being issued with considerably lower interest rates, the corporation could find itself tied into a high rate for many years. If the company continued to finance its loans at the old, higher rate, it would be at a competitive disadvantage.
To avoid the foregoing scenario, companies are often willing to pay a premium to redeem bonds before they mature. Callability allows the corporation to react to changing interest rates, refinance high-interest obligations, and avoid paying more for long-term debts than the market rate.