What is a Callable Bond?
A callable bond (redeemable bond) is a type of bond that provides the issuer of the bond with the right but not the obligation to redeem the bond before the maturity date. The callable bond is a bond with an embedded call option. The bonds generally come with certain restrictions.
For example, the bonds cannot be redeemed in the first periods of their lifespan. In addition, some types of callable bonds allow the redemption of the bonds only in case of some extraordinary events. After redemption, the (callable) bonds are canceled.
On the other hand, callable bonds bear much higher risk to the investors. If the bonds are redeemed, the investors will lose some future interest payments (the event is also known as refinancing risk). Due to the riskier nature of the bonds, they tend to come with a premium to compensate the investors for the additional risk.
Generally, the majority of callable bonds are municipal or corporate bonds.
How do callable bonds work?
To understand the mechanism of callable bonds, let’s consider the following example.
ABC Corp. issues bonds with a face value of $100 and a coupon rate of 6.5% while the current interest rate is 4%. The bonds will mature in 10 years.
However, the company issues the bonds with an embedded call option to redeem the bonds from investors after the first five years.
The call option implies that if the interest rate decreases after five years, ABC Corp. may call back the bonds and refinance its debt with new bonds with a lower coupon rate. In such a case, the investors will receive the bond’s face value but will lose future coupon payments.
However, if the interest rate increases or remains the same, there will be no incentive for the company to redeem the bonds and the embedded call option will expire unexercised.
How to find a value of a callable bond?
Valuing callable bonds differs from valuing regular bonds because of the embedded call option. The call option negatively affects the price of a bond because investors lose future coupon payments if the call option is exercised by the issuer.
The value of a callable bond can be found using the following formula:
- Price (Plain – Vanilla Bond) – the price of a plain-vanilla bond that shares similar features with the (callable) bond.
- Price (Call Option) – the price of a call option to redeem the bond before maturity.
CFI offers the Financial Modeling & Valuation Analyst (FMVA)™ certification program for those looking to take their careers to the next level. To keep learning and advancing your career, the following resources will be helpful: