Callable Bonds - Fixed Income (2024)

FAQs

Are callable bonds fixed-income? ›

Callable Fixed Income Securities. A call option provides the issuer with the benefit of redeeming a bond prior to its maturity. Bonds are generally called when interest rates decline; therefore investors remaining in the market must reinvest in lower yields.

Callable bonds are more risky for investors than non-callable bonds because an investor whose bond has been called is often faced with reinvesting the money at a lower, less attractive rate. As a result, callable bonds often have a higher annual return to compensate for the risk that the bonds might be called early.

There are disadvantages to the callable bond holder because the bond proceeds likely would be reinvested in lower-yielding options. Investors are generally rewarded with slightly higher yields relative to a noncallable bond to compensate for the risk of an early call; the amount of extra yield varies, however.

Callable bonds allow issuers the option to redeem the bond before its maturity date. These bonds can be advantageous for issuers during periods of falling interest rates, allowing them to refinance at lower rates. Investors receive higher interest rates on callable bonds to compensate for the risk of early redemption.

Types include government bonds, corporate bonds, and certificates of deposit. There are also mutual funds and ETFs, which hold a large number of bonds in one fund, allowing investors to easily diversify their fixed-income investments.

Bonds, such as U.S. Treasuries and corporate or municipal bonds, are traditional types of fixed income investments.

What happens to callable bonds when interest rates rise? Callable bonds are less likely to be redeemed when interest rates rise because the issuing corporation or government would need to refinance debt at a higher rate. As with other bonds, callable bond prices usually drop when interest rates rise.

Yield to worst is a measure of the lowest possible yield that can be received on a bond with an early retirement provision. Yield to worst is often the same as yield to call. Yield to worst must always be less than yield to maturity because it represents a return for a shortened investment period.

First, Figure 3: Callable Bond as Share of Total Issues shows a rise in callable bonds, which were less than half of new issuance in 2008, to over 70 percent of new corporate debt issuance in 2019. Issuers can redeem callable bonds before maturity and often do so when market interest rates are falling.

Callable bonds with sinking funds may be called back early removing future interest payments from the investor. Paying off debt early via a sinking fund saves a company interest expense and prevents the company from being put in financial difficulties in the future.

How to value callable bonds? ›

Thus the price of a callable bond is the value of the straight bond less the value of the call option [2]. The value of the call option must converge to zero if the bond price is lower than the strike price or the bond close to maturity.

A bond's convexity is the rate of change of its duration, and it is measured as the second derivative of the bond's price with respect to its yield. Most mortgage bonds are negatively convex, and callable bonds usually exhibit negative convexity at lower yields.

Key Takeaways

Callable bonds can be called away by the issuer before the maturity date, making them riskier than noncallable bonds. However, callable bonds compensate investors for their higher risk by offering slightly higher interest rates.

Callable bonds sometimes offer a better interest rate than similar noncallable bonds to help compensate investors for the call risk and the reinvestment risk that they face. Sometimes callable bonds will also set the call price above face value—say $1,002 versus $1,000.

The benefit of issuing a callable bond is that it would reduce the agency cost of debt if the investment opportunities turn out to be bad. The cost is that the firm would incur the refunding cost if the investment opportunities turn out to be good.

However, since a callable bond can be called away, those future interest payments are uncertain. The more interest rates fall, the less likely those future interest payments become as the likelihood the issuer will call the bond increases.

Typically, in a traditional bond, there is a coupon, which may be regarded as the interest you receive for lending your money. The coupons are paid at fixed intervals, quarterly, semi-annually or annually. As this becomes a source of regular income for the investor, bonds are also known as Fixed Income products.

Treasury notes and Treasury bonds are fixed-income securities issued by the U.S. government but differ in maturity dates. Treasury notes have maturities of up to 10 years, while Treasury bonds have maturities of up to 30 years. Both notes and bonds pay interest every six months and the face value is at maturity.

Bond funds are similar to stock funds because they invest in a diverse selection of investments—but they hold fixed income securities instead of stock.