What is Noncallable?
Noncallable, also called non-redeemable, refers to the type of securities that cannot be called (redeemed) by their issuer(s) before their maturities unless penalties are paid to security holders. Two common examples are noncallable bonds and noncallable preferred stocks.
Most Treasury and municipal bonds are noncallable. Issuers of noncallable securities bear more risks and are sold at higher prices than issuers of callable securities.
- Noncallable refers to securities that cannot be called (redeemed) by their issuers unless penalties are paid to the security holders.
- Callable securities can be redeemed by the issuers in the circumstances or days specified in the call provision.
- Noncallable securities protect investors from reinvestment risk, but limit the issuers’ flexibility to restructure their financing. Therefore, investors in callable securities are compensated with a call premium from issuers.
Noncallable vs. Callable
The issuer of a noncallable security cannot redeem or buy back the security unless a penalty is paid. Conversely, a callable security can be redeemed by its issuer in particular circumstances or days specified in the call provision.
A call provision is settled when a callable corporate bond or preferred share is issued. It stipulates the triggering events for the call option, for example, when the asset price or interest rate reaches a specific value, or on a specific date.
A callable security gives the issuer greater flexibility to restructure their debts, but greater reinvestment risk to investors when the security is redeemed. Therefore, callable securities are usually issued at lower prices than the noncallable securities with the same nature to compensate the investors.
Treasury securities and municipal bonds are noncallable in general. If a bond is completely noncallable, the issuer cannot redeem this bond during the entire term to maturity. The issuer must pay the interest specified in the contract regardless of the change of the rate in the current market. Thus, the issuer bears interest risk.
When the market rate drops, the issuer must continue to pay the higher original interest according to the contract, which leads to a higher cost of financing. However, holders of noncallable bonds can benefit from this guaranteed interest rate and get protected from reinvestment risk.
Corporate bonds are often callable. Callable bond issuers have the option to choose whether to redeem the bond before its maturity or not. Compared with noncallable bond issuers, callable bond issuers bear much lower interest risk.
When the market rate drops to a certain level, the issuer can redeem the bond by paying the principal and interest up to the date, then issue another bond at the lower current market interest rate. The bondholders are thus exposed to reinvestment risk, as they need to reinvest at the lower return of lending.
To compensate the bondholders for the risk, a callable bond usually pays a higher interest rate than a noncallable bond, which means that the price of a callable bond is usually lower. The value of a callable bond is the value of a straight (neither callable nor puttable) bond minus the value of the call option.
Many bonds include both a callable term and a noncallable term. They are noncallable for a period of time after the issuance and turn callable after that. The noncallable time period is known as the call protection period in which bondholders receive guaranteed interest payments regardless of the change in the current market rate.
The relationship between the yield and value of a noncallable bond can be plotted as a convex curve. The price of the bond drops with an increase in yield and raises with a decrease. The change in price is more sensitive to a decrease than an increase in yield.
Callable bonds show the same pattern as noncallable bonds as yield increases because it is less likely for issuers to redeem when the market rate goes up. However, when the market rate goes down, the possibility of redemption raises, which makes it riskier to bondholders.
Thus, when the interest rate decreases, the price increase of a callable bond is much smaller than that of a noncallable bond. The lower the market rate, the less increase in the callable price.
Noncallable Preferred Stock
Noncallable preferred stocks are similar to noncallable bonds in that the issuer cannot buy back the preferred shares at a specified price. Noncallable preferred shares better protect investors from reinvestment risk than callable shares.
The issuers of callable preferred shares can buy back the shares when they have the opportunity to reissue shares at a lower dividend rate. To redeem shares, the issuer usually needs to pay investors a price higher than the par value as compensation for their reinvestment risk. The part of the value that the issuer pays above the par price is the call premium.
Callable preferred shares generally have a call protection period, which is predetermined in the call provision. The issuer is only allowed to redeem after the call protection period.
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