Callable or redeemable bonds, as the name implies, are bonds that are redeemable or callable by the bond issuer before they have matured. Note, however, that not all callable bonds are redeemed before maturity. Issuers don't always exercise their right to redeem the bonds due to market conditions.
Callable or redeemable bonds come with a call feature. Bonds have 3 major types of call features, and they are:
If the bond contract has an optional redemption feature, the issuer of the bond has the option of paying off their bondholders after a specific, preset interval has passed.
The duration after which the bond issuer may exercise its option to redeem its bonds is clearly defined in the optional redemption provision. Bonds with an optional redemption feature are usually callable within several years of their issue (e.g. after 10 years).
- Sinking fund
A callable bond with a sinking fund redemption feature stipulates that the issuer of the bond, at periodic intervals, set aside funds to be used for paying off their bonds.
Redeemable bonds may also have an extraordinary redemption feature. This redemption feature stipulates specific circumstances under which the issuer may redeem their bonds earlier than their maturation date. Some bonds' contracts, for instance, may include the provision that the bond is redeemable if the project for which the bonds were issued is cancelled.
Callable Bonds and Interest Rates
Bond issuers usually redeem their bonds when the prevailing interest rate is lower than the interest rate on their bond issues. By calling their bonds in when the market interest rate is low, they can "refinance" their projects. In other words, they can pay off high-interest bonds now so they can issue new bonds with a lower interest rate.
When a Bond Is Redeemed Early
When a callable bond is paid off by its issuer, the investor receives an amount equal to the call price or the face value of the bond plus the total interest that has been accrued so far.
In a market where the prevailing interest rate is lower than the bond interest rate, the early redemption feature does not favor bond investors. In such a market environment, bond investors may well have to reinvest the proceeds of the early redemption in bonds with a lower interest rate than the redeemed bonds.
Callable Bond Investing Strategy
There are advantages to investing in redeemable bonds, of course. Because they are more risky than straight bonds or bonds with no call or redeem feature, they are usually priced lower than the latter. Additionally, callable bonds generally come with a higher interest rate than straight bonds.
For all its advantages, you cannot ignore its risks. Thus, generally speaking, you should not buy a redeemable bond at prices above their face value at the time of purchase.
Buying a redeemable bond at a premium, moreover, is even more imprudent if the bond's callable date is near at hand. Remember that bonds, when called, are redeemable at their face value. Since you purchased these bonds at a premium rate or at higher than their face value, the total value of your bond investment at the time of redemption may actually be less than your total purchase costs. After all, the period between purchase and redemption is considerably short. Your interest earnings in that period, therefore, may not be enough to cover your excess investment.
As a final note, you should read all the pertinent documents related to a particular bond before buying it. You should ascertain the nature of the bond - is it a straight bond or is it a callable bond? If the bond comes with a call provision, you should find out when the bond may be redeemed and whether this gives you enough time to recoup (and profit from) your investment.
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