What Are Callable Bonds – Its Examples, Types And Why Do Companies Issue Them
The Government and corporations issue bonds to borrow money from investors. The investors invest in the bonds and the issuer gets the funds that they seek. In return, the issuer usually promises a fixed interest rate on the principal that the investor invests. A callable bond is a type of bond wherein the issuer reserves the right to redeem the bond before its maturity date. The bond comes with a clause that the issuer might, at its discretion, pay back the principal amount to the investor, before the stipulated tenure and call back the issued bond.
Read on to understand how callable bonds work, their types, examples, benefits and how it is different from non-callable bonds.
How Do Callable Bonds Work?
Issuers who feel that the interest rates might fall in the future issue callable bonds so that they can benefit from the reduced interest rates. If the interest rates do fall, they call back the bond and then issue new bonds at reduced rates to raise funds at lower interest outgoes.
However, while issuers have the right to redeem the bond prematurely, they are not obligated to do so. So, the issuer might not redeem the bond before maturity if it does not stand to gain from such redemption.
In the case of premature redemption, the issuer offers to redeem the bonds at a price higher than the face value or par value. This excess amount is called the call premium which seeks to reward the investor for the loss of interest on redemption before the maturity date. However, as the call date approaches maturity, the call premium reduces. If the issuer does not redeem the bond before maturity, no call premium is paid. The bond is redeemed at its face value.
In some cases, there might be a call protection clause. This clause stipulates the time period during which the issuer cannot redeem the bond. This clause is, usually, applicable during the initial tenure of the bond though it depends on the issuer to determine the call protection period.
What Are the Types of Callable Bonds?
Usually, callable bonds are, themselves, a type of bond. They do not have any further categories or variations. However, depending on the entity issuing the bond, callable bonds can be municipal bonds or corporate bonds.
Then there is a sinking fund concept too wherein the issuer follows a predefined schedule to redeem the bonds partially or fully.
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Example of a Callable Bond
To understand how the bond works, let’s use a callable bond example –
For instance, say company XYZ issues a callable bond of Rs.1000 per unit on 1st January 2022. The company stipulates a call protection period from 1st January 2022 to 1st January 2024. The bond has a maturity of five years and the interest rate is 8%.
In this case, the company cannot redeem the bond till 1st January 2024, i.e., during the call protection period. The bond would mature on 1st January 2027. The company can redeem the bond after 1st January 2024 and before 1st January 2027. Say the company redeems the bond on 1st December 2025 at a rate of Rs.1080 per unit. So, if you had invested in the bond, you would receive a call premium of Rs. 80 per unit of the bond that you hold.
What Are the Advantages of a Callable Bond?
Both investors and issuers can enjoy the benefits of callable bonds. The advantages of a callable bond can be highlighted in the following points for both the parties –
1. For Investors:
- Higher Interest Income: Most callable bonds are usually issued at a higher interest rate to attract investors. As such, if you invest in these bonds, you can get the benefit of enhanced interest income.
- Premium on Redemption: If the issuer redeems the bonds before maturity, it pays a call premium to compensate you for the loss of interest income. As such, you get a higher value on redemption of these bonds.
- Regular Income: The interest income is paid regularly throughout the bond tenure till the issuer redeems it. Moreover, you get guaranteed interest income during the call protection period. This guaranteed interest generates a regular stream of income which can serve as a passive income to supplement your savings.
2. For Issuers:
- Flexibility of Premature Redemption: Issuers have the flexibility of redeeming the bonds before maturity. As such, if they have surplus funds and want to cut down on the interest expense, they can redeem the bonds and save on the interest cost.
- Ease of Refinancing When Interest Rates Fall: Callable bonds give issuers the refinancing option at a reduced interest rate. When the interest rates fall, issuers can call back their bonds that have higher interest rates. They can, then, refinance the bond at lower rates to reduce interest expenses.
Callable Bond Risks
Though beneficial, there are various risks too that you, as an investor, might face when investing in callable bonds. The primary risk is the reinvestment risk. If the interest rates drop, the issuer tends to call back the bonds. While you might earn a call premium, you would face a reinvestment risk. If you want to invest in other bonds, the interest rates on such bonds would be lower given the reduced interest rates. So, you would have to search for a suitable debt instrument that offers a similar interest to minimize the loss.
Secondly, if the bond is called back, you would lose the interest income that you might have earned had the bond matured. Though you get a call premium, the premium might not compensate you adequately for the loss of interest income.
Why Do Companies Issue Callable Bonds?
Companies issue bonds to raise funds for their needs. Callable bonds are no exception. The only difference is that these bonds give companies the flexibility to redeem them before maturity or refinance the bond when interest rates fall. So, companies opt for callable bonds if they predict a reduction in the interest rates in the future or if they can secure a corpus to redeem the bonds before maturity. While raising capital, callable bonds also allow companies to cut down on interest costs by redeeming the bonds earlier than maturity.
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Callable Bonds vs Non-Callable Bonds
Callable and non-callable bonds are two opposite types of bonds. Here are the differences:
| Callable Bonds | Non-callable Bonds |
| These bonds give the issuer the right, but not the obligation, to redeem the bonds before their maturity date. | These bonds do not give the issue the right nor the obligation to redeem the bonds before their maturity date. |
| The interest rates are usually higher on these bonds since they can be redeemed before maturity | The interest rates are usually lower than callable bonds. |
| You might earn a call premium which is an amount in excess of the face value of the bond if the bond is redeemed before maturity | The concept of call premium does not exist since the bond is redeemed on its maturity date only. |
Final Word
As mentioned earlier, there are different types of bonds and callable bonds are one of them. So, understand what these bonds are all about before you invest in them. Assess the pros and cons of these bonds and their inherent risks. Invest in them only if they align with your financial needs and investment strategies.
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FAQs
Ans: No, callable and puttable bonds are not the same. In fact, they are completely opposite from one another. Here’s how:
• Callable bonds give issuers the chance to redeem the bond before maturity. Puttable bonds give investors the option to demand redemption of their bonds before maturity.
• Callable bonds carry a higher interest rate than puttable bonds.
• Callable bonds are redeemed at a premium while puttable bonds are redeemed at a discount.
• Callable bonds are favourable for issuers in the case of falling interest rates. Puttable bonds are favourable to investors in the case of rising interest rates.
• The put option can be exercised on any date. In the case of the call option, there is a call protection period after which the call option can be exercised.
Ans: Yes, the interest that you earn from a bond is taxable in your hands. The interest income is recorded under the category ‘income from other sources’ and added to your taxable income. You have to pay a tax at your income tax slab rates.
Ans: No, it is not mandatory to issue callable bonds. It depends on the requirement and strategy of the company issuing the bond. A company might issue callable bonds to fund its expenses or it can opt for other types of bonds too.
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This article has been prepared on the basis of internal data, publicly available information and other sources believed to be reliable. The information contained in this article is for general purposes only and not a complete disclosure of every material fact. It should not be construed as investment advice to any party. The article does not warrant the completeness or accuracy of the information and disclaims all liabilities, losses and damages arising out of the use of this information. Readers shall be fully liable/responsible for any decision taken on the basis of this article.
