Callable Bonds (also known as Redeemable Bonds)

A callable bond is a type of bond that gives the issuer the right—but not the obligation—to buy back the bond from the investor before its scheduled Maturity Date. Think of it as a corporate loan with an early-repayment option for the borrower (the issuer). Why would they do this? The main reason is to take advantage of falling interest rates. If a company issued bonds paying a 6% Coupon Rate and market rates later fall to 4%, they can “call” the old, expensive 6% bonds and issue new ones at the cheaper 4% rate, saving a bundle on interest payments. For the investor, this creates a significant risk. The bond is most likely to be called when you least want it to be—when interest rates are low, forcing you to reinvest your money at less attractive rates. This is known as Reinvestment Risk. To compensate investors for taking on this risk, callable bonds almost always offer a higher initial Yield than comparable non-callable bonds.

When a company issues a callable bond, the terms of the early redemption are clearly defined in the bond's indenture (its legal agreement). These terms specify exactly when and at what price the bond can be called.

• Call Protection Period: This is a lock-up period right after the bond is issued during which the issuer is not allowed to call it. This gives the investor a guaranteed window to receive the promised coupon payments. A typical protection period might be 5-10 years on a 30-year bond.
• Call Dates: After the protection period ends, the bond can be called on specific dates, usually on coupon payment dates. The schedule of these dates is set from the start.
• Call Price: This is the price the issuer must pay to redeem the bond. It is almost always set at or above the bond's Par Value (its face value). The difference between the call price and the par value is called the call premium. Often, the call price is highest on the first possible call date and then declines over time, eventually reaching par value.

Imagine “Euro Gadgets SA” issues a 10-year callable bond with a par value of €1,000 and a 7% coupon. The bond has a 3-year call protection period. After that, it can be called on the first call date at a Call Price of €1,035 (103.5% of par). If, four years from now, interest rates have fallen to 4%, Euro Gadgets will likely exercise its option. It will pay you €1,035 to take back your bond, and you will lose out on six more years of 7% interest payments. Now, you have €1,035 to reinvest, but new, similar-quality bonds are only paying 4%.

The primary motivation is financial efficiency. Issuers call bonds to:

• Refinance Debt at Lower Rates: This is the most common reason. Just as a homeowner refinances a mortgage when rates drop, a company refinances its debt to lower its interest expense, which boosts its profitability.
• Alter the Company's Capital Structure: A company might want to reduce its overall debt level. If it has a surplus of cash from strong business operations, it can use that cash to call its bonds and clean up its Balance Sheet.
• Remove Restrictive Covenants: Some bond agreements contain clauses (covenants) that restrict the company's financial activities. By calling these bonds, the company can free itself from those constraints.

For a value investor, callable bonds present a classic trade-off between risk and reward. The key is to analyze if you are being adequately compensated for the risks you are taking.

The call feature puts a ceiling on your potential profit.

• Capped Upside: As interest rates fall, the price of a regular (non-callable) bond rises. However, the price of a callable bond will rarely rise much above its call price, because no sane investor would pay €1,100 for a bond that the issuer could snatch back for €1,035 next month. This effect is known as Price Compression.
• Reinvestment Risk: As mentioned, the bond will be called at the worst possible time for you, leaving you to find a new home for your capital in a lower-yield environment.

A smart investor never relies solely on the Yield to Maturity (YTM) when analyzing a callable bond. YTM assumes the bond will be held until its full maturity, which may not happen. Instead, you must also calculate the Yield to Call (YTC).

• Yield to Maturity (YTM): The total return you'll get if you buy the bond today and hold it until it matures.

1. Yield to Call (YTC): The total return you'll get if you buy the bond today and it gets called by the issuer on the earliest possible call date.

A prudent value investor always makes decisions based on the Yield to Worst (YTW), which is simply the lower of the YTM and the YTC. If a bond is trading at a discount to par, its YTM will likely be lower. If it's trading at a premium, its YTC will almost certainly be lower. By using the lower of the two figures, you are using the most conservative and realistic estimate of your potential return. If that “worst-case” yield still meets your investment criteria and adequately rewards you for the call risk, the bond might be a worthy investment.