It’s the perennial question among investors.
What is a callable bond?
A callable bond is a type of bond that an issuer can redeem or “call back” before its maturity date. The issuer does this by paying a call premium over the par value to the bondholder. A bond is redeemable if, before its maturity date, the issuer returns the investor’s principle and stops future payments of interest.
The call date on a callable bond varies with the issuer, but it can be found in the bond’s prospectus. Many municipal bonds are callable after 10 years. A five-year, high-yield bond might be callable after two years.
Some corporate bonds and most municipal bonds are callable, where the issuer has flexibility when borrowing in terms of loan length and payment amount.
If rates have declined from the time the company or city first issued the bond, the issuer may want to refinance its debt at a lower interest rate. After calling its current bonds, the issuer can then reissue them at a lower interest rate.
The earlier a bond is called, the more its value increases, since the bond can be called just above the par value. Unlike a noncallable bond, a callable bond pays a higher coupon to an investor.
In this era of low interest rates, callable bonds by companies and cities have gained in popularity. In 2015, $1 trillion in callable corporate bonds were issued, compared to $234 billion in 2005.
To be sure, the impact of a bond being called can be significant, especially if an investor had mistakenly factored it in as fixed income. That person is left with a gap in anticipated income.
Callable bond example
The Sharp Razor Co. offered a callable bond on Nov. 1, 2016, with a 10 percent interest rate, maturing on Oct. 30, 2021. Assume the issue amount is $100 million and the bond is callable at intervals after one year, subject to a 30-day notice, here is its value (as in the schedule below):
- Oct. 30, 2017 (Call date for one year) = 110 percent of face value.
- Oct. 30, 2018 (Call date for two years) = 108 percent of face value.
- Oct. 30, 2019 (Call date for three years) = 106 percent of face value.
- Oct. 30, 2020 (Call date for four years) = 104 percent of face value.
In this example, Sharp Razor has an option to redeem the bonds from investors before the bonds mature on Oct. 30, 2021. The original call premium is higher at 10 percent of the bond’s face value, and over time it gradually declines to 4 percent.
Do you want to report interest income? Learn more about paying taxes on savings bond interest.