Callable Bond

A callable bond is a bond that includes an embedded call option. The call option is an issuer option—that is, the right to exercise the option is at the discretion of the bond’s issuer. The call provision allows the issuer to redeem the bond issue prior to maturity. A callable bond is also called a redeemable bond.

Early redemption usually happens when the issuer has the opportunity to replace a high-coupon bond with another bond that has more favorable terms, typically when interest rates have fallen or when the issuer’s credit quality has improved.

Until the 1990s, most long-term corporate bonds in the United States were callable after either five or 10 years. The initial call price (exercise price) was typically at a premium above par, the premium depended on the coupon, and the call price gradually declined to par a few years prior to maturity. Today, most investment-grade corporate bonds are essentially non-refundable. They may have a “make-whole call,” so named because the call price is such that the bondholders are more than “made whole” (compensated) in exchange for surrendering their bonds. The call price is calculated at a narrow spread to a benchmark security, usually an on-the-run sovereign bond such as Treasuries in the United States or gilts in the United Kingdom. Thus, economical refunding is virtually out of question, and investors need have no fear of receiving less than their bonds are worth.

Most callable bonds include a lockout period during which the issuer cannot call the bond. For example, a 10-year callable bond may have a lockout period of three years, meaning that the first potential call date is three years after the bond’s issue date. Lockout periods may be as short as one month or extend to several years. For example, high-yield corporate bonds are often callable a few years after issuance. Holders of such bonds are usually less concerned about early redemption than about possible default. Of course, this perspective can change over the life of the bond—for example, if the issuer’s credit quality improves.

Callable bonds include different types of call features. The issuer of a European-style callable bond can only exercise the call option on a single date at the end of the lockout period. An American-style callable bond is continuously callable from the end of the lockout period until the maturity date. A Bermudan-style call option can be exercised only on a predetermined schedule of dates after the end of the lockout period. These dates are specified in the bond’s indenture or offering circular.

With a few exceptions, bonds issued by government-sponsored enterprises in the United States (e.g., Fannie Mae, Freddie Mac, Federal Home Loan Banks, and Federal Farm Credit Banks) are callable. These bonds tend to have relatively short maturities (5–10 years) and very short lockout periods (three months to one year). The call price is almost always at 100% of par, and the call option is often Bermudan style.

Tax-exempt municipal bonds (often called “munis”), a type of non-sovereign (local) government bond issued in the United States, are almost always callable at 100% of par any time after the end of the 10th year. They may also be eligible for advance refunding—a highly specialized topic that is not discussed here.

Although the bonds of US government-sponsored enterprises and municipal issuers account for most of the callable bonds issued and traded globally, bonds that include call provisions are also found in other countries in Asia Pacific, Europe, Canada, and Central and South America. The vast majority of callable bonds are denominated in US dollars or euros because of investors’ demand for securities issued in these currencies. Australia, the United Kingdom, Japan, and Norway are examples of countries where there is a market for callable bonds denominated in local currency.

References

2018 CFA Program Level II Volume 5 Fixed Income and Derivatives.

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