12: CALL FEATURES ON BONDS Bonds and Bond Derivatives, Second Edition Book
Callable bonds typically pay a higher coupon or interest rate to investors than non-callable bonds. Should the market interest rate fall lower than the rate being paid to the bondholders, the business may call the note. This flexibility is usually more favorable for the business than using bank-based lending. However, the investor might not make out as well as the company when the bond is called. For example, let’s say a 6% coupon bond is issued and is due to mature in five years.
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- Of course, you can prepare for a call only before it happens.
- Most likely a schedule will state the bond’s potential call dates and its call premium.
- Calls usually come at a very inconvenient time for investors.
- This way, the corporation won’t have to keep paying five percent to its bondholders if interest rates drop to 2% to 4% after the issue is sold.
- However, locating bonds without call features might not be easy, as the vast majority tend to be callable.
Finally, companies must offer a higher coupon to attract investors. This higher coupon will increase the overall cost of taking on new projects or expansions. Many bonds issued today are “callable,” which means they can be redeemed by the issuer at set points before its listed maturity date. That means the issuer pays investors the call price and any accrued interest, and doesn’t make any future interest payments. Like with call options, a callable bond gives companies the right—but not the obligation—to buy back its bonds at a set price. New issues of bonds and other fixed-income instruments will pay a rate of interest that mirrors the current interest rate environment.
An investor purchases $10,000 worth and receives coupon payments of 6% x $10,000 or $600 annually. Three years after issuance, the interest rates fall to 4%, and the issuer calls the bond. The bondholder must turn in the bond to get back the principal, and no further interest is paid. Although the prospects of a higher coupon rate may make callable bonds more attractive, call provisions can come as a shock. Even though the issuer might pay you a bonus when the bond is called, you could still end up losing money.
Callable bonds thus compensate investors for that potentiality as they typically offer a more attractive interest rate or coupon rate due to their callable nature. An issuer will usually call the bond when interest rates fall. This calling leaves the investor exposed to replacing the investment at a rate that will not return the same level of income. Conversely, when market rates rise, the investor can fall behind when their funds are tied up in a product that pays a lower rate.
Laddering, for example, is the practice of buying bonds with different maturity dates. If you have a laddered portfolio and some of your bonds are called, your other bonds with many years left until maturity may still be new enough to be under call protection. And your bonds nearer maturity won’t be called, because the costs of calling the issue wouldn’t be worth it for the company. While only some bonds are at risk of being called, your overall portfolio remains stable.
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A rising rate environment will likely dictate a different strategy than a stagnant one. If you own a callable bond, remain aware of its status so that, if it gets called, you can immediately decide how to invest the proceeds. To find out if your bond has been called, you will need the issuer’s name or the bond’s CUSIP number.
Let’s look at an example to see how a call provision can cause a loss. Say you are considering a 20-year bond, with a $1,000 face value, which was issued seven years ago and has a 10% coupon rate with a call provision in the tenth year. At the same time, because of dropping interest rates, a bond of similar quality that is just coming on the market may pay only 5% a year. You decide to buy the higher-yielding bond at a $1,200 purchase price (the premium is a result of the higher yield).
It reissues the bond with a 4% coupon rate and a principal sum of $10.2 million, reducing its annual interest payment to 4% x $10.2 million or $408,000. If market interest rates decline after a corporation floats a bond, the company can issue new debt, receiving a lower interest rate than the original callable bond. The company uses the proceeds from the second, lower-rate issue to pay off the earlier callable bond by exercising the call feature. As a result, the company has refinanced its debt by paying off the higher-yielding callable bonds with the newly-issued debt at a lower interest rate. As we mentioned above, the main reason a bond is called is a drop in interest rates.
Then you can check with your broker or a number of online publishers. ABC International issues a bond that contains a requirement for the issuer to pay 108% of the par value of a bond if it calls the bond. You can also search FINRA’s Fixed Income Data by issuer to see which of that issuer’s bonds are callable and which are not. You buy a bond, get paid a coupon, and then get the face value back at maturity, right? If you don’t read a bond’s prospectus carefully or discuss with your broker to determine whether the bond is callable, you might end up making a lot less on that bond than you were anticipating.
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A lower credit rating generally translates into high interest rates, since a worse rating implies that investing in that company carries a higher degree of risk than it did previously. Of course, you can prepare for a call only before it happens. Some bonds are freely-callable, meaning they can be redeemed anytime.
Before buying a callable bond, it’s also important to make sure that it, in fact, offers a higher potential yield. Find bonds that are non-callable and compare their yields to callable ones. However, locating bonds without call features might not be easy, as the vast majority tend to be callable. Suppose that three years go by, and you’re happily collecting the higher interest rate.
The bond may also stipulate that the early call price goes down to 101 after a year. Finally, don’t get confused by the term “escrow to maturity.” This is not a guarantee that the bond will not be redeemed early. This term simply means that a sufficient amount of funds, usually in the form of direct U.S. government obligations, to pay the bond’s principal and interest through the maturity date is held in escrow. Any existing features for calling in bonds prior to maturity may still apply. Call protection refers to the period when the bond cannot be called.
Callable Bonds: Don’t Be Surprised When Your Issuer Comes Calling
Plus, you might not be able to reinvest the cash at a similar rate of return, which can disrupt your portfolio. Over time the proportion of corporate bonds containing call options has varied. At times, the large majority of bonds have had call features. When interest rates have been high, the proportion of callable bonds appears to have been relatively high, and when interest rates have fallen, the proportion of callable bonds has been relatively low. Thus, the issuer has an option which it pays for by offering a higher coupon rate. In this scenario, not only does the bondholder lose the remaining interest payments but it would be unlikely they will be able to match the original 6% coupon.
Optional redemption lets an issuer redeem its bonds according to the terms when the bond was issued. Treasury bonds and Treasury notes are non-callable, although there are a few exceptions. A callable—redeemable—bond is typically called at a value that is slightly above the par value of the debt. The earlier in a bond’s life span that it is called, the higher its call value will be. This price means the investor receives $1,020 for each $1,000 in face value of their investment.
A sinking fund helps the company save money over time and avoid a large lump-sum payment at maturity. A sinking fund has bonds issued whereby some of them are callable for the company to pay off its debt early. Fixed-income investors in low-interest-rate environments often discover that the higher rate they receive from their current bonds and CDs doesn’t last until maturity.
The issuer must clarify whether a bond is callable and the exact terms of the call option, including when the timeframe when the bond can be called. At such a time, you as a bondholder should examine your portfolio to prepare for the possibility of losing that high-yielding asset. Even though you pay the capital-gains tax, you still make a profit. If your bond is called and you aren’t expecting it, it can have a significant impact on your expected return on investment from that bond. Moreover, if you are counting on the steady stream of income from the coupon, you might find that stream dried up, and you might not be able to find a suitable replacement investment for that cash. Extraordinary redemption lets the issuer call its bonds before maturity if specific events occur, such as if the underlying funded project is damaged or destroyed.
Are All Call Options the Same?
Technically speaking, the bonds are not really bought and held by the issuer but are instead cancelled immediately. A bond call price is the contractually-mandated price at which a bond holder must sell a bond back to the issuer. This call price is stated in the bond indenture, which may also state the date range within which a bond can be called. Outside of this date range, the issuer cannot buy back its bonds. The bond issuer usually triggers the call option when interest rates decline; this presents an opportunity for the issuer to replace the bonds with ones that have a lower interest rate. The call price is the price paid to bondholders when the bond is called.
Three years from the date of issuance, interest rates fall by 200 basis points (bps) to 4%, prompting the company to redeem the bonds. Under the terms of the bond contract, if the company calls the bonds, it must pay the investors $102 premium to par. Therefore, the company pays the bond investors $10.2 million, which it borrows from the bank at a 4% interest rate.
A callable bond, also known as a redeemable bond, is a bond that the issuer may redeem before it reaches the stated maturity date. A callable bond allows the issuing company to pay off their debt early. A business may choose to call their bond if market interest rates move lower, which will allow them to re-borrow at a more beneficial rate.