In recent years, investment in securities has gained tremendous ground among laypersons. This positive development in investor confidence can be attributed to newer, coming-of-age digital platforms making investments easier. Options like mutual funds are gaining currency rapidly, allowing individuals to utilise their excess income in financially fruitful ways.
However, the financial market features a vast array of securities, like a callable bond. Any individual newly stepping into the market can find it perplexing, which further undermines their capacity to undertake proper investment decisions. Hence, it is essential to educate oneself in the ways of such securities.
What is a Callable Bond?
Bonds are essentially fixed-income instruments. If securities are to be classified, two broad types emerge – equity and fixed-income instruments. With the latter, investors earn income at fixed, stipulated intervals. Thus, it hedges individuals against market volatility and provides a sense of security.
That is what bonds are in general. Per callable bond meaning, however, there’s less security for the investor. These bonds come embedded with a call option. That means the issuer enjoys the right to redeem the bonds before the maturity period. While other attributes of a callable bond are similar to any other fixed-income instrument, the call option is where it differs.
Organisations usually issue these bonds when there’s a sign of interest rates moving downwards in the future. Thereby, when market interest rates actually dip, they can redeem such bonds and issue fresh ones in lieu at a lower coupon rate.
To make such a financing option attractive for investors, issuing bodies typically offer a higher interest rate than what is prevalent in the market. Or else, an issuer might promise redemption at a rate higher than the face value of such bond.
How do Callable Bonds Work?
A callable bond essentially functions as a standard, vanilla bond. However, there’s uncertainty on the part of an investor regarding whether they’ll continue to earn interest till maturity. Since the issuer possesses the right and not an obligation to exercise the call option, it might not redeem the securities before the maturity date.
Due to the latent risk of this security type, investors also enjoy a higher income than holders of standard bonds. There can be two ways of compensation, as mentioned above, i.e. either a higher coupon rate or redemption at a premium.
Here, the premium rate at which an issuer calls the bonds depends on the period left to its maturity. The earlier an issuer redeems the bond, the more substantial will be the premium.
Take, for instance, Company XYZ issues a callable bond with a maturity period of 10 years. However, five years into the issuance, it decides to redeem the bonds at a premium of 2%. Thereby, if a creditor possesses a bond at Rs.100, he will receive Rs.102 on redemption. Now, the bond offering might host a stipulation that pronounces a premium of 1% if it’s redeemed any time after 5 years.
How is a Callable Bond Valued?
As one might guess, callable bonds are valued differently than a standard bond. In fact, vanilla bonds are priced higher than callable bonds because of the latter, featuring a call option.
In general, callable bond valuation takes place in the following manner –
Callable bond value = Standard bond’s price – Price of a call option
The price of a call option depends on the coupon rate and period left to maturity. This system ensures that the issuer does right by an investor.
What’s an Example of Callable Bond?
A callable bonds example can clarify the dynamics of this security type more comprehensively. Let’s take a look at the details of a callable bond that Company PQR issues on 1st April 2020.
|Maturity date||1st April 2030|
|Borrowed amount||Rs.10 lakh|
As per the bond offering, if PQR exercises its call option prior to 1st April 2025, it shall pay a premium of 3% to the par value. If it’s later than 1st April 2025, the premium value shall be 1%.
On 2nd May 2024, PQR declares that it will redeem the debentures because market interest rates dipped to 4%. Thereby, it pays investors Rs.1030000, which PQR avails by issuing another debt at 4%.
Therefore, via this instrument, the company could refinance its high-interest loan with a relatively cheaper one.
What are the Different Types of Callable Bonds?
In strict terms, there aren’t any callable bond types. However, they may vary based on stipulations set by the issuer. For instance, some callable bonds come with a predetermined period of 5 years or so before which it cannot be redeemed. Usually, this period is referred to as call protection.
Then there’s sinking fund as well. In this case, the issuer goes by a preset schedule for redeeming bonds in parts or full. Hence, it stops the users from incurring a substantial cost of redemption at once. Instead, it can disburse portions of the bond value from time to time.
What are the Pros of a Callable Bond?
The advantages that an investor and an issuer can derive from callable bonds are –
Callable bonds provide a higher value to investors than other fixed-income instruments. This makes it a lucrative option for investors looking to enhance the earning potential of their portfolio without assuming high-risk like that of equities.
- Fixed stream of income
It provides investors with a sure stream of income for the period that it is held. That, combined with a higher interest rate, makes it a more profitable option compared to standard bonds.
- Flexible financing option
Companies can leverage their call option anytime outside the call protection period. This eases the obligation of serving a debt at higher coupon rates when market interest rates are low.
What are the Cons of a Callable Bond?
The disadvantages it presents to investors and issuers are –
- Replacement with a low-income instrument
When callable bonds are redeemed, investors may need to shift to a low-income debenture or assume higher risk by investing in stocks. Either way, it’s a compromise.
- Servicing a higher rate
Issuers need to incur a higher cost with callable securities than they would have had to with a vanilla bond. This increases the overall expense of projects financed through such callable bonds.
From an investor’s perspective, therefore, callable bonds are ideal if they want to earn higher returns than a traditional fixed-income instrument while agreeing with the uncertainty of redemption before maturity.