A callable bond (or redeemable bond) is a bond whose indenture includes one or more call provisions providing for the early retirement (“call” or “redemption”) of the bond. Call provisions may provide for optional redemption, extraordinary redemption or sinking fund redemption. When included in a bond’s indenture, extraordinary and sinking fund redemption are “boiler plate” provisions that usually afford the issuer little opportunity to benefit at investors’ expense. Form an investment standpoint, it is optional redemption that is interesting or a cause for concern. This article focuses exclusively on callable bonds with optional redemption provisions.
Such bonds are especially popular in the United States, where corporate bonds and municipal bonds are often callable. US Treasuries generally are not callable. Most callable bonds are coupon bonds. Convertible bonds are often callable. Zero-coupon bonds sometimes are.
A call provision need not be exercised to the bond holder’s economic detriment. For example, an issuer might exercise a call provision to retire a secured bond whose indenture places unwanted restrictions on the sale of collateral. This might be inconvenient for investors, but it would do them little economic harm. Such redemptions are rare. Generally, a bond is called when it is economically beneficial for the issuer to do so—and economically detrimental to bond holders. The typical scenario is that interest rates fall, so the issuer calls the bonds and issue new bonds at the lower interest rates. Such a transaction is called a refunding. It benefits the issuer, but investors are forced to surrender their high-coupon bonds and reinvest in the lower interest rate environment.
In the secondary market, callable bonds don’t exhibit the same price sensitivities as non-callable bonds. If interest rates drop, a non-callable bond’s market price will rise. This tendency is muted in a callable bond, since falling interest rates make it likely that the bond will be called. Once the first call date has passed, the bond’s clean price won’t generally rise above the call price. As is apparent in Exhibit 1, callable bonds tend to have a shorter duration and lower convexity than do comparable non-callable bonds.
A callable bond can be thought of a non-callable bond bundled with a short call option on that non-callable bond:
callable bond = non-callable bond – call option
The bond holder is short the call option, and the issuer is long the call option. The option has economic value, so the issuer compensates investors with a higher nominal yield than would be payable on a comparable non-callable bond. That higher yield is like an option premium the issuer pays the bond holder for the call option.
The bundled short call option makes callable bonds difficult to analyze. The yield on a non-callable bond depends upon interest rates and the issuer’s credit quality. The yield on a callable bond depends upon both of these and the value of the embedded call option. This makes yields on callable and non-callable bonds not directly comparable. Also, yields on two callable bonds cannot be directly compared either, since their call features may differ in terms of call protection, call schedules and the degree to which the call options are in-the-money or out-of-the-money. Further complicating matters, the value of the call option depends on the volatility of interest rates, which can change unpredictably.
There is also the question of what measure of yield to consider when comparing bonds. Nominal yield and current yield are problematic with any bond. While yield to maturity is useful for comparing non-callable bonds, it is somewhat meaningless for callable bonds—which may be called long before they mature. Yield measures designed specifically for callable bonds—such as yield to first call or yield to worst—offer an indicating of value that is crude at best.
Sophisticated analysis of callable bonds requires the use of financial engineering techniques that simultaneously value the credit risk, interest rate risk and optionality of a callable bond. Few investors have the resources to perform such analyses.