What Is a Callable Bond?

The debt market features a plethora of different fixed-income securities, each with its own set of advantages and disadvantages. Among the many debt instruments available, very few are as versatile as the callable bond. Although they might seem complex at first, they are fairly easy to understand. In this guide, we shall explore what a callable bond is, how it works, and how interest rate changes impact it. 

Also Read More About What are Bonds?

Callable Bond or Callable Debt 

A callable bond, also known as callable debt, is a unique type of bond that gives the issuing company the right to redeem it earlier than the stipulated maturity date. However, a key point to note here is that the issuing entity only gets the right but not the obligation to redeem it before the maturity date. This essentially means that the issuing company may continue to keep the bonds active until the original maturity date if it chooses to.   

While the flexibility that a callable bond offers can be highly advantageous to the issuing company, it introduces an aspect of uncertainty for the investors. To compensate for the increased risk and uncertainty, companies issuing callable bonds often tend to offer higher interest rates (coupon rates). Additionally, the issuing entity may also choose to repurchase the bonds at a slight premium in the case of an early redemption.  

How Does a Callable Bond Work?

Before we look at an example of a callable bond, let us first understand the various terms associated with this debt instrument. Every callable bond has two key factors that you need to know about: call date and call price. 

• Call date: It is the date after which the issuing company can redeem the bond. 
• Call price: The call price, meanwhile, is the price at which the bond shall be redeemed. Usually, the call price is set slightly higher than the issue price (at a premium) to compensate the investors for the early redemption. 

Let us now consider a hypothetical example of a callable bond to understand how it works. 

Assume there is a company ABC Limited. The company requires ₹50 crore to expand its business. To raise the funds, it decides to issue 5 lakh callable bonds, each with an issue price of ₹1,000. The bonds have a 10-year tenure and a 9% annual coupon rate. The company sets a call date that is three years from the date of the initial issue and the call price at 110% of the issue price.

Now, three years later, the interest rates in the market drop to around 7.5% per annum. Since the interest rates have fallen, ABC Limited decides to redeem the bonds early and sends out a call notice to its investors. 

To complete the early redemption, the company must pay ₹1,100 (₹1,000 x 110%) for each bond that it redeems from the investors. In this case, the total outlay for the company would be ₹55 crore (5 lakh callable bonds x ₹1,100). Once ABC Limited repays its investors, the callable bonds would then be cancelled.

However, if the company still requires funds, it could reissue new debt instruments at the new, lower interest rate of 7.5% per annum. This would reduce the borrowing costs for the company to the tune of ₹75 lakh per annum [₹50 crore x (9% – 7.5%)]. 

Impact of Interest Rate Changes on Callable Bonds

The interest rate in the market can significantly influence callable bonds. For instance, if the market rates fall, issuers can call the bonds and refinance by issuing new bonds at lower rates. 

Meanwhile, if the interest rates rise, issuing companies can continue keeping the callable bonds active until maturity as calling them and reissuing new debt instruments at higher rates would be highly disadvantageous.

Advantages of Callable Bonds

Callable debt instruments offer a range of advantages for both the issuing companies as well as the investors. Here is a quick overview of some of the key benefits of these instruments. 

• Flexibility

Callable bonds provide financial flexibility to the issuing companies by giving them the freedom to manage their debt obligations more effectively. For instance, if the issuing company generates more revenue than anticipated, it could use the additional funds to redeem the callable bonds and lower its financial burden. 

• Interest Savings 

Callable bonds can be highly advantageous in declining interest rate environments. Issuing companies can call the bonds and refinance their debt at lower interest rates to reduce their borrowing costs. 

• Higher Income

Investors of callable bonds get to enjoy higher coupon rates as compared to non-callable bonds. The higher rate is often offered to compensate for the increased risk that investors have to take up.  

• Redemption Premium 

In addition to higher fixed income, investors may also get to receive a premium above the face value of the bond during early redemption. The premium is an additional source of income and is offered to compensate for the loss of interest income. 

Disadvantages of Callable Bonds

Although callable bonds have advantages, they also come with a fair share of downsides for both investors and the issuing companies. Let us take a look at what they are. 

• Higher Initial Costs

Issuing companies must offer higher coupon rates and redeem the bonds at a premium to attract investors towards callable bonds. This increases the cost of borrowing significantly. 

• Market Timing Risk

Issuing companies must call the bonds at the right time to maximise the benefits of refinancing. If they miss the optimal window to call the bonds due to an unexpected change in the market conditions, it could lead to major losses.    

• Reinvestment Risk

Investors might have to deal with reinvestment risk if the issuing company opts to exercise the call option. Reinvestment risk is the risk of having to reinvest the principal at lower rates, which could be a possibility if the bond is called due to a falling interest rate environment. 

• Uncertainty 

Since callable bonds have the possibility of early redemption, investors must deal with an element of unpredictability. This can be highly disadvantageous since there is no way for investors to know when the issuer will exercise the call option.

Conclusion

Callable bonds are a highly unique debt instrument that provides flexibility to the issuing company and higher returns to investors. However, despite the many advantages, callable bonds have certain risks that must be accounted for before investing. If you plan to invest in callable bonds, it is crucial to ensure that the debt instrument aligns with your overall investment strategy, risk profile, and financial objectives. 

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