Callable Bond

What Is a Callable Bond?

A callable bond is a bond that gives the issuer the right, but not the obligation, to repay the principal early, before the stated maturity date. The issuer does this by "calling" the bond at a predetermined price, usually at or slightly above par value. Callable bonds are common among corporate and municipal issuers. They are sold with a call schedule that lists the dates and prices at which the issuer may redeem the bond.

How a Callable Bond Works

Before the first call date, the bond is usually protected for a period known as call protection, during which the issuer cannot redeem it. After that, the issuer may call the bond on the dates set out in the schedule. The call price is often higher at first and declines toward par over time.

Issuers usually call bonds when market interest rates have fallen. If rates drop, the issuer may be able to borrow more cheaply, so it repays the existing bonds and issues new ones with a lower coupon. The investor then receives the principal back and must reinvest it, possibly at lower yields.

Because the issuer holds this option, investors generally expect extra compensation. As a result, callable bonds often offer a higher coupon rate or yield than comparable non-callable bonds.

Why Callable Bonds Matter to Investors

Investors evaluate callable bonds using yield to maturity and yield to call. Since the bond could be redeemed early, many analysts also look at yield to worst, which is the lowest yield an investor could receive across the possible call dates and the maturity date.

Callable bonds carry risks that ordinary bonds do not. Reinvestment risk is the main one: the bond may be repaid just when new bonds pay less. Price gains are also limited. When rates fall, a callable bond's price tends to rise only to around its call price, because buyers expect it may be redeemed. A non-callable bond has no such ceiling.

A higher stated yield on a callable bond may therefore reflect the risk of early repayment. The call schedule and call price are listed in the bond's offering documents.