Callable- vs Regular Bond

A callable bond is a type of bond that includes a provision allowing the issuer to repay the bond before its maturity date. This feature is known as a "call option." The issuer can "call" the bond at a predetermined call price, often at a premium to the bond's face value, after a specified call protection period. Callable bonds provide issuers with flexibility to refinance debt if interest rates decline or if their creditworthiness improves, allowing them to issue new bonds at a lower cost.

Features of Callable Bonds

• Call Option
  The call option embedded in callable bonds gives issuers the right to redeem the bonds before maturity. The terms of the call option, including the call dates and call prices, are specified at the issuance of the bond.
• Call Protection Period
  Callable bonds typically have a call protection period during which the bond cannot be called. This period varies but usually lasts several years from the issuance date, providing investors with some assurance that they will receive interest payments for a minimum period.
• Yield Considerations
  To compensate for the call risk, callable bonds usually offer higher yields compared to non-callable (regular) bonds. This higher yield is an incentive for investors to accept the additional risk that the bond may be redeemed early.

How Callable Bonds Differ from Regular Bonds

• Interest Rate Risk
  Callable bonds and regular bonds (non-callable) differ significantly in their response to interest rate changes. Regular bonds do not have a call feature, so their prices fluctuate based on changes in interest rates, credit risk, and other market factors. Investors in regular bonds can be confident that they will receive interest payments until the bond matures, provided the issuer does not default. In contrast, the price of callable bonds is influenced by the issuer's option to call the bond. If interest rates decline, the issuer is likely to call the bond to refinance at a lower rate. This potential limits the price appreciation of callable bonds, as the call feature caps their upside. Investors in callable bonds face reinvestment risk because they might have to reinvest the returned principal at lower prevailing interest rates.
• Yield and Compensation
  Callable bonds typically offer higher yields than regular bonds to compensate investors for the call risk. The possibility of the bond being called before maturity means investors might not receive the bond's interest payments for as long as initially expected. The higher yield serves as an incentive to attract investors despite this uncertainty.
• Market Price Behavior
  The market price of callable bonds can be more volatile than that of regular bonds. When interest rates drop, the value of a callable bond may not rise as much as that of a regular bond because of the likelihood that the bond will be called. Conversely, if interest rates rise, the callable bond will behave more like a regular bond, decreasing in value as the likelihood of being called diminishes.

Please log in to see the discussion.