Callable Bonds or Redeemable Bonds are those bonds that can be retired by the issues before the bonds’ maturity date. The issuer can call the bonds as per the terms defined anytime after the lockout period. When it does, the issuer has to pay face the value and accrued interest to the date.
Once the issuer has redeemed bonds, there will be no interest payments after that. Investors find callable bonds attractive as they offer higher returns than noncallable bonds. But, the higher returns come with a price. And, that is the call risk.
The callable bonds provide the issuer the flexibility to redeem the bond anytime. So, when interest rates fall, the issuer would call the bond. As interest rates fall, the issuer would replace the debt with the one where they have to pay a lower interest rate. This way they can refinance their debt.
Lockout Period
The issuer can’t call a bond before a specific time period, Lockout Period. It can range from three months to ten years. From the issuers’ perspective, it is better to have a shorter Lockout period. Issuers find shorter Lockout periods favorable to them. But, the shorter the Lockout period, the higher will be its yield and vice versa.
Risks to the Investor
The investor faces a reinvestment risk. If the issuer calls the bond then, the investor has to invest the principal and accrued interest in some other security. And, the issuers call a bond in a falling interest rate environment. The investor can’t invest the amount in a security that has comparable returns. So, they have to reinvest in securities that offer lower yields.
Apart from that, the investor doesn’t know when the issuer will call a bond. So, they can’t plan their investments in advance. Quite possible that the issuer, in some cases, wouldn’t call the bond till the maturity date. Or, they call the bonds early.
In conclusion, callable bonds pose a greater risk to investors as they can be called anytime after the lockout period. So, the investors are compensated with higher yields for taking the call risk.
Important: This material is provided only for information purposes only. It doesn’t constitute investment advice. We shouldn’t be held liable for the investment decisions readers take. We encourage readers to act at their discretion.
