Callable Bond Explained - Definition, Benefits & Risks

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Bonds are debts which are issued by different types of organizations to raise funds from investors.In most cases, bonds are not callable which means that the bond issuer cannot be called away or paid off before the maturity date. However, callable bonds enable the bond issuers to do that. Those bonds can be called away by the issuer before the maturity date, and this makes the bond be more risky than those noncallable bonds. To compensate the investors for those risks, callable bonds will offer a higher coupon rate than the noncallable bonds. So, for a callable bond, it may end at the maturity date or be recalled at an earlier call date. In both cases, the bond issuers will pay off the bond by returning the investors' money.

Why Entities Issue Callable Bonds
The reason for the bond issuer to choose a callable bond is that they are uncertain about the interest change in the future, and they need to make decisions to call or keep the bonds based on the trend of the interest in the future. For example, if a company is issuing a 20-year callable bond with a coupon rate of %, and it can be callable after 5 years. If the interest is lower than 5% by then, say 2%, the company can choose to call the bond and refinance the debt at a lower interest rate. Conversely, if the interest rate rises to 7% after 5 years, the bond issuer can choose to keep the bond because the bond is cheaper than the market rate. For investors, if the interest rate is expected to be unchanged during the life span of the bond, the callable bonds can be considered as a good investment because they offer a higher coupon rate than the non-callable ones. If it is estimated that the interest rates will be changed greatly in the future, no matter if it will go up or go down, the risk of callable bonds will be getting bigger. If the interest rate is going up, the bond issuer will keep the bond and the original coupon rate, which makes you unable to put your money into a higher yield investment. On the contrary, if the interest rate is going down, the bond will call the bond earlier than the maturity date and you may not be able to have a good investment option by then.

Benefits Of Callable Bonds
Due to the uncertainty of the callable bonds, the bond issuers will usually offer a higher coupon rate than other non-callable bonds. They may also offer a callable face value which is higher than the one on the maturity date. For example, if a bond's face value on the maturity date is $1000, if the entity decides to call the bond before the maturity date, they may need to pay $1030 to the investors as the compensation. Also, for most call bonds, investors do not need to pay the bond premium, which means they do not need to pay more than the face value when investing the bond. Since there is also a possibility that the bond will not be called at all. If that is the case, investors can get the benefits of a high coupon rate for the whole term, which makes it a good investment.

Risks Of Callable Bonds
The biggest risk for the callable bonds is the reinvestment risk when the bond is called away before the maturity date. Let's revisit the previous example, if a company is issuing a 20-year callable bond with a coupon rate of 5%, and it can be callable after 5 years. If the interest is lower than 5% by then, say 2%, the company may choose to call away the bond. Although investors may get some compensation from the calling away, they will find it difficult to find another bond having a high coupon rate because the interest rate is getting lower by then, which will bring down the bond coupon rates as well. This uncertainty will be called reinvestment risk. Another risk of the callable bonds is the sensitivity to the expected lower interest rates in the future. As we know, a lower interest rate in the future will make the bond price go up. This is because a lower interest will make the bond's current high coupon rate more valuable, and thus push up the price. However, due the uncertainty about if the bond will be called away by the issuer when the interest rate is getting lower, the price of the bond may not go up as other noncallable bonds do. Of course, this risk doesn't not exist if the interest rates are expected to rise in the future.

In summary, the higher coupon rates from a callable bond come at the price of reinvestment risk and diminished price-appreciation potential. All of those will help you add some callable bonds into your diversified investment portfolios.