They may lose some return during the transfer of investment to the other companies. The bondholder will receive the premium fee in exchange for the early redemption. These bonds are issued by various urban local bodies like municipal corporations or municipalities. They come with a call feature which issuers can exercise only after completion of a certain time period, like 5 years or 10 years. It involves a complex calculation to arrive at the yield on a redeemable bond.

However, their market price depends on interest rate movements and time to the put date. When rates rise, these bonds hold value better since investors can redeem them at a predetermined price. Liquidity varies by issuer and demand, but their put feature provides an alternative exit option beyond secondary market trading. Puttable bonds are valued as the sum of a comparable non-puttable bond and the embedded put option. The put option increases the bond’s redeemable bond price since it gives investors downside protection. Factors like interest rates, credit risk, and time to the put date influence valuation.

• On the other hand, if the borrower ends the loan before schedule, the creditor needs to look for the opportunity to invest the loan in other places.
• You may expect the interest payments to continue until the bond reaches its maturity date.
• 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.
• This calling leaves the investor exposed to replacing the investment at a rate that will not return the same level of income.
• The value of a plain (non-puttable) bond, which represents the bond’s standard cash flows (coupon payments and principal at maturity).

For example, if the bond purchase agreement states that the bond is callable at 103, you’d receive $1.03 for every $1 of the bond’s face value. Just as you might want to refinance your 6% mortgage if interest rates dropped to 3%, Company XYZ will want to refinance its debt to save money on interest. Issuers typically include a call provision that allows them to redeem their bonds early, which allows them to refinance the debt at a lower interest rate.

What is a callable bond?

The redeemable debt allows the option for borrower to pay off before the majority date. It can save them some cost if the market rate falls below the current interest rate, but they need to pay the premium to the creditors. Management must compare to ensure the cost saving is higher than the premium paid.

• Fixed-income investors will lose the steady stream of income and will likely need to put their money in a lower-yielding investment unless they’re willing to accept more risk.
• Moreover, some bonds will be eligible for redemption only in extraordinary situations.
• Issuers raise capital financing, and issuers invest in slightly higher interest rate instruments.
• The Reserve Bank of India has facilitated the issuance of government securities with both call and put options.

Features of Puttable Bonds

However, you face reinvestment risk if bonds are called during periods of declining interest rates. Investors like callable bonds because they offer a slightly higher yield than noncallable bonds. Investors who believe interest rates will rise may prefer to take that higher yield despite the call risk since issuers are less likely to redeem bonds when interest rates rise. Also, many corporations see their credit ratings tumble during difficult times. Corporations whose creditworthiness took a hit likely issued callable bonds in hopes of improving their creditworthiness and eventually issuing new debt at a lower rate. Understanding the general relationship between interest rates and bonds is helpful in understanding how callable bonds work.

Difference between a Callable Bond vs. Puttable Bond

Investors might have mixed feelings about callable bonds as they offer higher coupon rates but also have reinvestment risks and uncertainties. Callable bonds compensate you for the redemption risk through higher coupon rates. This premium reflects the possibility of early redemption, which could force you to reinvest at lower rates.

Callable (or Redeemable) Bonds: Types and How They Work

The issuers cannot redeem the debt without a special clause in such cases. When interest rates fall below the redeemable debt rates (bond coupon), issuers look for cheaper financing options. The redeemable clause protects the issuers against the interest rate risk. Investors are practically left with little choice but to reinvest in the new bonds with lower interest rates. Issuers raise capital financing, and issuers invest in slightly higher interest rate instruments.

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.

For risk compensation, the issuers usually offer higher interest rates on callable or redeemable debt than irredeemable debts. 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. 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.

Even though callable bonds offer a slightly higher yield than noncallable bonds, stocks are typically a much bigger driver of growth in your portfolio. For most investors, particularly those who have a long time until retirement, stocks should make up the bulk of their investment portfolio. This calling leaves the investor exposed to replacing the investment at a rate that will not return the same level of income.

Example of callable bond issuances in the real world

For instance, a corporation might issue a 20-year callable bond with a 5% coupon rate but retain the right to redeem it after five years if interest rates decrease substantially. 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. The investor might choose to reinvest at a lower interest rate and lose potential income. Also, if the investor wants to purchase another bond, the new bond’s price could be higher than the price of the original callable. In other words, the investor might pay a higher price for a lower yield.

This limits price appreciation and creates reinvestment risk for bondholders. The yield to call becomes a more critical metric than yield to maturity in these scenarios. The primary distinction between callable and non-callable bonds lies in their redemption features.

Additionally, the investors would be able to save on interest by repaying the debt in full before maturity. A callable bond offers several advantages to the issuers and investors. There are several different types of callable bonds that vary based on when the issuer is allowed to redeem the bond. If Company XYZ redeems the bond before its maturity date, it will repay your principal early.

Conversely, when market rates rise, the investor can fall behind when their funds are tied up in a product that pays a lower rate. This higher coupon will increase the overall cost of taking on new projects or expansions. Since issuers assume a greater risk by granting this flexibility, puttable bonds typically offer investors lower yields compared to non-puttable bonds. However, if you value liquidity and risk mitigation, their benefits often outweigh the yield sacrifice. Investors would receive higher coupon payments for reinvestment and interest rate factors.

If you’re relying on a steady income, you may be better off taking a slightly lower yield and sticking with noncallable bonds. If you opt for callable bonds, consider how you’d reinvest your money if interest rates drop and your bonds are redeemed. Issuers are protected against the falling interest rate risks with a redemption clause. The obvious risk with debt instruments comes with changes in the interest rates. Interest rate risks make debts split into variable and fixed interest rate instruments.

Puttable bonds allow investors to sell them back early, protecting against rising rates. Investors in puttable bonds trade higher yields for flexibility, while issuers of callable bonds offer higher yields due to their control. For issuers, callable bonds offer valuable flexibility in managing their debt structure and interest rate exposure.