Special type of bonds that can be called early by the issuing company and retrieved from the bondholder before reaching the maturity date.
Also known as redeemable bonds, they are special types of bonds that can be called early by the issuing company and retrieved from the bondholder before reaching maturity. These bonds usually offer higher interest rates due to their callable features.
Corporations usually issue bonds to fund their financial activities. It is one of the ways that companies use to raise money. The investors and the issuer agree on an amount of money that the investor lends to the issuer in return for periodic interest payments.
Issuers usually issue bonds with a call feature to raise money in a safer way in which they can call the bonds when interest rates go down and issue new ones with lower interest payments.
Even though issuers call these bonds back when interest rates drop, leaving investors with reinvestment risk, they are still a good investment when interest rates remain unchanged, which is usually the case.
As a result, investors will receive higher interest payments than standard bonds throughout the bond's life. That is why investment in such bonds is never a bad idea for investors, and obviously, the same goes for companies demanding funds.
Redeemable bonds are strategic debt instruments companies use when they expect the market rates to drop during a given period.
The bond issuer has the right to call it before reaching the maturity stage stated; thus, the bond offers higher interest rates for its holders as compensation.
Companies use bonds to finance their activities, and this type of bond helps them achieve that by giving them the right to recall these bonds when market rates drop and issue other bonds with lower interest rates.
A redeemable bond has a higher par value than that of the debt. The earlier the bond is recalled, the higher its value will be.
- Suppose a company issues a bond that matures in 2030.
- The company then recalls the bond at an early stage, say 2025.
- The callable price in 2025 May be 105$; thus, for every 1000$ face value investment, the holder will receive 1050$
- The callable price of the bond will be lower at later stages and may become 104$ in 2026.
The issuing company will pay more than the bond's par value to retrieve it. Still, they will benefit from issuing other bonds that return lower interest rates when the market rate goes down, enabling them to borrow money at lower costs.
Types of callable bonds
Not all types of bonds are callable. Treasury bonds and notes are non-callable bonds with few exceptions.
However, there are various types of these bonds, such as
1. Optional Redemption: the issuer has the right to redeem the bond after a specific period set and agreed upon. Municipality bonds are examples of such types where the period set before calling bonds is ten years.
2. Sinking Fund Redemption: The issuer redeems the bond at the scheduled dates set and pays the investor portions of the debt.
They pay portions of the debt each period using their sinking funds' account, which allows companies to save money and avoid paying enormous amounts at once.
- Suppose a company issues a 10-year bond with a $5 million par value.
- It is required to pay 10% of the bond each year
- Thus, the company will use its sinking funds and pay $500,000 yearly.
3. Extraordinary Redemption: The issuer has the right to call bonds before the maturity date at par value due to unusual events and circumstances. This feature should be stated in the bond offering statement.
- Extraordinary Redemption allows the issuer to redeem the bonds when an unusual event hits the source revenue of the company.
- Redeeming the bonds may be optional or mandatory, depending on what is stated on the offering statement.
- An example of Extraordinary Redemption is an airline company that issues a bond and plans to pay it from revenues generated from its services. However, due to Covid-19, flights were stopped due to lockdowns, and the company has the right to call the bond.
How do interest rates affect callable bonds?
Companies issue bonds to finance their activities and compensate investors with interest payments paid each period until the maturity date. However, with these bonds, that's not always the case. Interest rates play a significant role in determining whether a bond will be called early or not.
When a company issues a bond with the call feature, they compensate the investor with a slightly higher interest rate than that of a non-callable bond or the normal market return rate.
However, when the market-rate decreases, the issuer can now call the bond and issue a new one to refinance their debt with a lower interest rate bond. This helps companies reduce their interest expenses and protect them against financial challenges.
Additionally, when interest rates increase more than the market rate, companies would keep the bonds till their maturity rate since they would be financing themselves with lower interest payments.
On the investor side, they would receive higher interest rates than a regular bond unless the market changes in the interest rates occur. They would also benefit when companies call the bonds since they are obligated to pay more than the bond's par value as of the date of the call.
For example, the bond may be issued at a par value of 1000$, and a company would pay 1040$ when they call the bond.
When market rates are down, investors who gave away the bonds when the issuer calls them may want to reinvest, but this time with lower interest rates, the price of bonds could be trading higher than previous bonds. This is called Reinvestment risk.
In general, these bonds offer a variety of advantages and disadvantages for either party, such as
|Gives the issuer the ability to call bonds and reissue new ones with lower interest rates.||Leads to reinvestment risk for the investor.|
|Earns investors higher interest rates than the market.||Costs companies to pay higher interest rates, thus increasing interest expense.|
|Grants investors higher bond par value when they are called.||Takes away the ability of investors to make use of high-interest rates when market rates rise.|
|Assist in financing companies and gaining capita.||Costs companies to pay a higher par value when they call the bond early.|
How to calculate the returns of callable bonds?
To calculate the anticipated value of projected returns of such bonds, we use what we call yield. Yields display earnings earned by an investment over a period shown as a percentage of the amount invested or the bond's face value.
High yield refers to lower risk and higher returns. However, that's not always the case, as sometimes high yield refers to increasing dividends on a falling stock.
Yield measures the cash flow of the investor's securities. It is calculated on an annual basis, as well as quarterly and monthly yields.
Not all yield measurements are used to anticipate the value of bonds with the callable feature. We use different types of measures to calculate yield:
- Yield to worst
- Yield to call
Other yields are incompatible with these bonds, such as yield to maturity, since it only measures the returns to the maturity date and does not anticipate bonds' value before that date. Moreover, current yield calculates the returns of bonds according to their market price instead of face value.
Yield to call measures the bond's return over the period in which the bondholder keeps the bond until the call date or when the issuer decides to call back bonds from bondholders. We assume that the bond is called at the nearest possible date.
To calculate yield to call, we use:
- Interest rate
- Time till call date
- Bond's market price
- Call price
Yield to call formula:
Numerator: coupon + (call value - price) / time of bond
Denominator : (face value + price) / 2
To illustrate, we take the following example:
Assume that Mr.X owns a callable bond from IBM with a face value of $1000 at a 5% zero-coupon rate. The bond's maturity date is four years, which can be called after three years at 105% of par value. In this case, we assume the bond would be called after three years. Thus, the bond's call price would be 105% ( $1000*105%).
The price for acquiring the bond is $920, and the market price is $980. The coupon payment is $50.
Therefore, YTC = [ 50 + (1050 - 920) / 20) / (1000 + 920) /2 ] = 50 + 65 / 960 = 12%
Yield to Worst (YTW)
Yield to worst is another measurement used by investors to anticipate the yield of their bonds. Since their bonds have a callable feature, they predict they will be called as soon as interest rates go down, and that's why investors measure the minimum they would receive from the bond before it is called.
To determine yield to worst, we first have to calculate yield to maturity, which anticipates how much returns a bond would earn the investor if they hold it till the maturity date.
To calculate yield to maturity, we use the following formula:
Numerator: C + (FV - PV) / t
Denominator: (FV + PV) / 2
C = interest / Coupon payment
FV = Face value of the security
PV = Present value of the security
t = time till maturity
After we determine the yield to maturity, we then calculate the yield to call by the formula mentioned earlier, and we take the lowest rate out of the two yields as yield to worst.
For example, assume an investor measures his bond's yield to maturity, which turns out to be 5%, and his yield to call is 4%. Thus 4% will be the investor's yield to worst.
- A callable bond is a bond that can be called early by the issuer company.
- It offers a win-win situation for the issuing company and investors, as issuing companies may call the bonds when they expect market rates to go down. Investors will receive higher interest rates and higher par value when bonds are called early.
- Companies issue these types of bonds to finance their activities more safely by protecting themselves from fluctuation in market rates.
- They are of three types: Optional Redemption, Sinking Fund Redemption, and Extraordinary Redemption.
- Optional Redemption gives the issuer the right to call bonds after a set period.
- Sinking Fund Redemption lets the issuer redeem bonds at fixed intervals and pay portions of the debt each.
- Extraordinary Redemption gives the issuer the right to call the bond when an unusual event has caused damage to the issuer's source of revenue.
Although these bonds can be called at any time when interest rates fall, leaving the investor with reinvestment risk, these bonds aren't necessarily bad for investors since, most of the time, the issuer won't call the bond.
Investors would keep receiving higher interest rates till the maturity date.
These bonds lack the appropriate demand, given the risk and uncertainty they provide for the investor. Thus, issuers must persuade people to invest in such bonds by offering higher interest rates.
The call feature adds significant value for the issuer, making these bonds typically cheaper than non-callable bonds. However, callable bonds provide a higher yield than non-callable bonds.
By studying the market, investors can predict the time a bond will be called. If the bond's trading price is higher than what they paid, they can sell it and make a profit before it is called.
Some bonds are freely-callable, meaning that an issuer might redeem them anytime they wish to. However, some bonds offer some kind of protection by stating the starting date at which the bond can be redeemed.
Once that date comes, the issuer can call the bond anytime and its premium price starts decreasing.
Convertible bonds are debt instruments that can be converted into equity shares during the bond life. However, callable bonds can't be converted into equity shares.
Puttable bonds are the exact opposite of callable bonds, as the investor has the right to demand repayment of the debt at any time they wish to. Just as bonds can be called from the issuer, there could be specified dates where the investor can start demanding the repayment.
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