Callable Bonds – What are They and How do They Work?
Callable bonds are bonds which contain an option giving the issuer of the bond the right to buy the bond back at a specified time and specific price. The price the bondholder will receive if a bond is called will always be at least the par value of the bond or higher.
Many municipal and corporate bonds are callable, however the reasons that a corporation or a municipality calls a bond may be very different:
- Corporations primarily call bonds because they can refinance the bonds at a lower rate (because market interest rates have dropped or their credit rating has improved).
- While municipalities may call a bond for the same reasons as a corporation, they have an additional reason: to slowly reduce their debt burden over time.
As a result, municipal bonds are more likely than corporate bonds to be called when interest rates are rising, and bonds values dropping. In this case, a bondholder would be happy to have invested in a callable bond which is called at a price which is above where the bond is currently trading.
There is tremendous variety in how the callable bonds are structured. Some bonds require the the issuer to call a certain amount of bonds by a certain date. Others give them the option of calling bonds, but it is not a requirement that they do so. Still in other cases, the issuer has the option of calling their bonds or buying them in the open market. Often only a portion of a bond issue is called. When this occurs, the exact bonds that are called is determined by lottery. How callable bonds are structured can greatly affect their value.
Before Purchasing Callable Bonds You Should Consider
1) What would be yield on the bond, if it was called at the earliest date? (also known as the yield to cal l.)
If a callable bond is selling at a price below its par value, no investor would mind having their bond called. The investor would get to “sell” the bond for an above market price, and would be able to reinvest the money with a higher yield than the bond’s coupon rate. A double win!
On the other hand, investors that own callable bonds with a market price above the call price don’t want to be called. The investor would take an immediate loss when compared to the bond’s current market price and not be able
find other bonds paying the same yield as they are currently receiving. A double loss! As a result, you might not want to buy a bond selling at a premium with a near-term upcoming call date. The bigger the premium of the bond, the more the call hurts the bondholder.
2) Is the call optional or required? If required, can the issuer buy the bonds in the market instead of calling bonds?
Generally speaking, the call feature favors the bond issuer. The most favorable type of call for the issuer, and worst for the bondholder, is when the call is completely discretionary. The best situation for bondholder is when the call is required and the issuer must redeem the bond from the bondholder at face value, regardless of market price. At least in this scenario, the bondholder might come out ahead if interest rates have risen.
Valuing Callable Bonds
Generally, the value of a bond can be evaluated in terms of its maturity. The return on a bond (Yield-To-Maturity ) is calculated based on receiving a stream of regular fixed dollar payments till the maturity date. However, in the case of callable bonds, the bond issuer can exercise a right to buy back the bonds before their maturity date. Therefore, instead of just calculating “Yield to Maturity” (YTM), you can also calculate “Yield to Worst” (YTW). In contrast to the Yield to Maturity, the Yield to Worst calculates return based on what happens if a bond is called away from you at the least favorable time.
Callable Bonds with Sinking Funds
A bond issuer may also set up a “sinking fund” into which it deposits money to be used for repurchasing its bonds (“retiring its debt”). A sinking fund can operate in different ways:
- It can repurchase a fraction of the bonds each year as they become available on the open market
- It can call bonds (as in the callable bonds above) at its discretion
- It can specify repurchase at the market price or the sinking fund price, whichever is lower, and decide on the bonds for repurchase by random selection of bond numbers
- If you decide to buy a bond associated with a sinking fund, it is important to understand the conditions under which the issuer can choose to repurchase the bond. This remains a choice and not an obligation for the issuer.
You can learn more about sinking funds here .Source: learnbonds.com