Callable Bond

A callable bond is a bond whose issuer holds the right to redeem it before the stated maturity date. The SEC's investor glossary defines callable bonds, also called redeemable bonds, as "Bonds that can be redeemed or paid off by the issuer prior to the bond's maturity date," and the MSRB's glossary describes a callable bond as "A bond that the issuer is permitted to redeem before the stated maturity at a specified price, usually at or above par, by giving notice of redemption in a manner specified in the bond contract." The opposite is a non-callable bond, which the issuer must leave outstanding until maturity.

The right belongs to the issuer, not the holder. That single fact explains the economics: an issuer exercises a call when doing so saves it money, so the holder is repaid early in exactly the conditions where the repayment is unwelcome. The corporate bond page describes the shape of that trade, capped upside and uncapped downside; this page covers the call feature itself as a contract term, what the schedule says, the three kinds of redemption, and the tax angles that attach to a call.

The call schedule is a set of dates and prices. The call date is, in the MSRB's words, "The date on which bonds may be called for redemption as specified by the bond contract." The call price is the price the issuer pays if it calls, "generally at or above par" and "stated as a percentage of the principal amount called," so a call price of 102 means $1,020 per $1,000 of face value. Anything paid above par is a redemption premium, or call premium, and the MSRB notes that such premiums "typically are paid only in the case of certain optional redemptions." A premium call price "often declines incrementally after the initial premium call date," so a schedule might read 102 in the first callable year, 101 the next, and par thereafter. On any call the holder also receives interest accrued to the redemption date.

Call protection is the period during which none of this can happen. The MSRB defines it as the redemption provisions "that partially protect an investor against an issuer's prepayment of the bonds prior to maturity," and gives the market's shorthand: an issue "that cannot be called for ten years after its issuance is said to have "ten years of call protection" or "ten-year no-call."" Between two callable bonds, the call protection matters as much as the coupon, because a higher coupon that can be taken away in two years is worth less than it looks.

Three kinds of redemption, and what triggers each. The SEC's investor glossary lists "three primary types of call features." An optional redemption "Allows the issuer, at its option, to redeem the bonds," and the SEC notes that many municipal bonds carry optional calls exercisable after a set number of years, often ten. A sinking-fund redemption "Requires the issuer to regularly redeem a fixed portion or all of the bonds in accordance with a fixed schedule," so it is mandatory rather than optional, and it means a holder may have part of a position retired early even when rates have not moved. An extraordinary redemption "Allows the issuer to call its bonds before maturity if certain specified events occur, such as the project for which the bond was issued to finance has been damaged or destroyed." The MSRB adds the vocabulary the contract itself uses: a redemption may be optional or mandatory, in whole or in part, at par or at a premium.

The make-whole call is the exception that protects the holder. The MSRB describes it as "A type of call provision allowing the issuer to pay off debt early that is designed to protect the investor from losses as a result of the earlier call," under which the issuer "must make a lump sum payment derived from a formula based on the net present value of future interest payments that will not be paid as a result of the call." Because that payment reproduces the value of the coupons the holder is losing, the MSRB observes that "such provisions are rarely used." A make-whole call is therefore a much weaker reason to discount a bond's price than an ordinary optional call at par.

Why issuers call, in the SEC's own comparison. "An issuer may choose to call a bond when current interest rates drop below the interest rate on the bond. That way the issuer can save money by paying off the bond and issuing another bond at a lower interest rate. This is similar to refinancing the mortgage on your house so you can make lower monthly payments." The SEC draws the consequence for the holder in the same passage: 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," and "As a result, callable bonds often have a higher annual return to compensate for the risk that the bonds might be called early." The reinvestment risk page covers that consequence in full. A callable bond is therefore measured by its yield to call and its yield to worst as well as its yield to maturity; the bond yield page defines those measures.

Two tax points attach to a call. First, for a holder who paid more than face value, IRC 171(b)(1)(B)(i) measures the amortizable premium on a taxable bond "with reference to the amount payable on maturity (or if it results in a smaller amortizable bond premium attributable to the period before the call date, with reference to the amount payable on the earlier call date)," so a premium callable bond may have to be amortized to the call date rather than to maturity. The bond premium page covers that mechanic. Second, for municipal issuers the tax law limits how early a refinancing can happen on a tax-exempt basis. IRC 149(d)(1) provides that "Nothing in section 103(a) or in any other provision of law shall be construed to provide an exemption from Federal income tax for interest on any bond issued to advance refund another bond," and 149(d)(2) defines the term: "a bond shall be treated as issued to advance refund another bond if it is issued more than 90 days before the redemption of the refunded bond." A current refunding, one in which the old bonds are redeemed within 90 days, remains available on a tax-exempt basis; the MSRB's glossary draws the same 90-day line. So municipal issuers still call and refinance their bonds, but they generally wait until inside the 90-day window before the call date to issue the replacement.

The bond contract sets the maturity date, the coupon, the first call date, the call price on each callable date, and the type of redemption. Through the protected period the bond behaves like any other bond. Once the first call date arrives, the issuer decides at each permitted date whether to redeem, and it gives notice in the manner the contract specifies. If it calls, the holder receives the call price plus accrued interest and the bond ceases to exist; if it does not, the bond runs on to the next call date or to maturity.

A hypothetical example with invented rates. Theo buys $10,000 face value of a 10-year corporate bond paying a 5 percent coupon, callable after five years at a call price of 102. For five years he collects $500 a year.

By the fifth year, market rates for comparable bonds have fallen to 3 percent. The issuer can now borrow at 3 percent, so it calls the bond. Theo receives 102 percent of $10,000, or $10,200, plus the interest accrued to the call date, and the bond is gone.

Reinvesting $10,200 at 3 percent produces 0.03 × $10,200 = $306 a year, against the $500 he had been receiving. Over the five years the original bond would have run, the income shortfall is ($500 − $306) × 5 = $970. The $200 call premium he received offsets part of that, leaving him about $770 worse off than if the bond had not been callable. The higher coupon he collected in the first five years, relative to what a non-callable bond of the same issuer would have paid, is what the market gave him up front for taking that risk.

Had rates risen instead, the issuer would not have called, and Theo would have kept his 5 percent bond in a higher-rate world for the remaining five years. The corporate bond page works through that asymmetry, capped upside and uncapped downside, with its own example.

Pros

• Pays a higher coupon than a comparable non-callable bond, because the holder is being paid for the option the issuer holds.
• Call protection guarantees a minimum period during which the coupon cannot be taken away, and a make-whole call substantially neutralizes the risk.
• A call at a premium returns more than face value, and the holder receives accrued interest to the redemption date.
• The redemption terms are fixed in the contract and disclosed in advance, so the risk can be measured, most directly through yield to worst.

Cons

• The issuer calls when rates have fallen, so the holder gets the principal back precisely when it can only be reinvested at a lower rate.
• The upside is capped: the bond's price will not rise far above the call price when rates fall, because the market expects the call.
• A sinking-fund redemption can retire part of a holding early on a schedule that has nothing to do with rates, and an extraordinary redemption can be triggered by events the holder cannot forecast.
• A callable bond bought at a premium may have to amortize that premium to the call date for tax purposes, and a call before maturity ends the holding period the buyer planned around.