Understanding Callable Bonds

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Corporations use bonds to raise funds. Investors are the lenders, giving money to businesses who promise to make interest payments to the investor. If the bond is callable, the issuer can call them back and pay the investor their principal plus any interest earned to that point.

Learn what happens when a callable bond is called by the issuer and what it means for investors.

Key Takeaways

  • When you buy a bond, you are lending money in exchange for a certain interest rate over a set number of years until the maturity date.
  • If a bond is callable, the issuer can call it back before the maturity date and pay you the interest you have earned up to that point.
  • When you buy callable bonds, you can lose income you expected to have, especially if you buy them on the secondary market too close to the call date.
  • Callable bond prices fall when interest rates fall, which makes them riskier than other bonds and potentially too complex for new investors.

What Is a Callable Bond?

When you buy a bond, you lend money in exchange for a set rate of return. You are essentially lending money to the seller. If a bond is callable, it means the issuer sells it to you and can "call" the bond back before the maturity date.

If you were to buy a low-risk, 15-year, AAA-rated corporate bond that pays yearly interest (also called its coupon rate) of 4%, you'd expect to collect an annual return of 4% for the next 15 years in exchange for your investment.

In most cases, the corporation that sold the bond has agreed to pay you a coupon rate of 4% for the next 15 years. However, sometimes a bond seller reserves the right to “call” the bond early—paying off the principal and accrued interest at that time, ending the loan before it matures.

These bonds are referred to as “callable bonds.” They are fairly common in the corporate market and extremely common in the municipal bond market.

Essentially, you've given your money to someone who promises to pay you interest—with the premise that they can give your money back to you whenever they want.

Callable Bond Risks

Buying a callable bond may not appear any riskier than buying any other bond. But there are reasons to be cautious. A callable bond exposes an investor to “reinvestment risk,” or the risk of not being able to reinvest the returns generated by an investment.

Investors achieve a small level of safety with bonds by locking in a desirable interest rate. A call not only throws a wrench into their investment plans, it means they have to buy another investment to replace it. Commissions or other fees add to the cost of acquiring another investment—not only did the investor lose potential gains, but they lost money in the process.

Here's an example—the Federal Reserve cuts interest rates, and the going rate for a 15-year, AAA-rated bond falls to 2%. Your bond issuer may decide to pay off the old bonds issued at 4% and reissue them at 2%.

As the investor, you will receive the original principal of the bond, but you will have difficulty reinvesting that principal and matching your initial 4% return. You can either buy a lower-rated bond to obtain a 4% return or buy another AAA-rated bond and accept the meager 2% return.

Examine the prospectus of the bonds you're interested in to find out if they're callable before you purchase them.

Bond market insiders know that one of the most common mistakes that novice investors make is to buy a callable bond on the secondary or over-the-counter market as rates are falling. The experienced investors know the “call date”—the day on which an issuer has the right to call back the bond—is approaching, and are selling to avoid the call.

They sell the bonds to the new investors, who believe they have found a great deal. The buyer may pay a principle of $1,000 plus a commission—and then promptly discover that the bond is called. That investor will receive the $1,000 back, but not the commission. It is money lost, and there is no recourse for the investor.

Should You Buy a Callable Bond?

Buying any investment requires that you weigh the potential return against potential risk. For entry-level investors, callable bonds may be too complex to consider. For example, the prices of callable bonds in the secondary market move quite differently from other bonds' prices.

When interest rates fall, most bond prices rise, but callable bond prices fall when rates fall—a phenomenon called “price compression.” However, callable bonds offer some interesting features for experienced investors. By calculating a callable bond's yield-to-call, investors can plan for a call and use it to their advantage.

A call is an extra layer of risk that you'll need to account for when considering bonds.

Pay Attention to Interest Rates

If you are considering a callable bond, the most significant factor is interest rates. What do you expect to happen to interest rates between now and the call date? If you think rates will rise or hold steady, you need not worry about the bond being called. However, if you think rates may fall, you should be paid for the additional risk in a callable bond.

Therefore, it pays to shop around. Callable bonds pay a slightly higher interest rate to compensate for the additional risk. Some callable bonds also have a feature that will return a higher par value when called; that is, an investor may get back $1,050 rather than $1,000 if the bond is called.

Make sure that the callable bond you buy offers enough reward to cover the additional risk you take on.