Callable Bonds Definition Example How It Works

What is a Callable bond?

The above is an example of Senior Secured Callable Bond due 22 March 2018 have been issued and registered with Verdipapirsentralen (VPS),

Callable bond = Straight/ Non callable bond + option

Please note that some of the callable bonds become non-callable after a specific period of time after they issued. This time is called ‘protection period’

Features

The issuer company has a right but not an obligation to redeem the bond before maturity.The call price is usually more than the issue price (Par price).The underlying security has a variable lifeThe call option may have multiple exercise rates.Generally, these bonds have a higher interest rate (Coupon rate).The premium for the option sold by the investor is incorporated in the bond by way of the higher interest rate.The call option generally has multiple exercise rates.

Example

Company ‘A’ has issued a callable bond on October 1, 2016, with an interest of 10% p.a maturing on September 30, 2021. The amount of issue is 100 crores. The bond is callable subject to 30 days’ notice, and the call provision is as follows.

In the above example, the company can call the bonds issued to investors before the maturity date of September 30, 2021.

If you see, the initial call premium is higher at 5% of the face value of a bond, and it gradually reduces to 2% with respect to time.

Purpose of issuing a callable bond

If interest rates are falling, the callable bonds issuing company can call the bond and repay the debt by exercising the call option and refinance the debt at a lower interest rate. In this case, the company can save interest costs.

For example, on November 1, 2016, a company issued a 10% callable bond with a maturity of 5 years. If the company exercises the call option before maturity, it must pay 106% of face value.

In this case, if, as of November 31, 2018, the interest rates fell to 8%, the company may call the bonds and repay them and take debt at 8%, thereby saving 2%.

Should we buy such bonds?

Before investing one has to balance return and risk. And callable bonds are too complex to deal with.Generally, when interest rates fall, normal bond prices go up. But, in the case of callable bonds, then bond prices may fall. This kind of phenomenon is called ‘compression of price.’These bonds generally have higher interest rates to compensate for the risk of being called early due to falling interest rates andThey are generally called at a premium (i.e., higher than the par value). This is due to additional risk investors take.For example, bond investors may get back Rs 107 rather than Rs 100 if the bond is called. This Rs 7 additional is given due to the investor’s risk if the company recalls bonds early in falling interest rates scenario.So, one has to ensure that the callable bond offers a sufficient amount of reward (maybe in the form of a higher interest rate than a market or maybe a higher repayment premium) to cover the additional risks that the bond is offering.

Structuring of Call Options

Before issuing the bond, one of the important and complicating factors in deciding the following two factors…

The timing of the call. I.e, when to, callDetermination of the price of the bond that is being called. How much to pay off bond is called before the due date

Timing of Call

The date on which the callable bond may be first called is the ‘first call date.’ Bonds may be designed to continuously call over a specified period or may be called on a milestone date. A “deferred call” is where a bond may not be called during the first several years of issuance.

There are different types in terms of timing

European optionEuropean OptionA European option can be defined as a type of options contract (call or put option) that restricts its execution until the expiration date. In layman’s terms, once an investor has purchased a European option, even if the underlying security’s price moves in a favourable direction, the investor cannot take advantage by exercising the option early.read more: Only a single call date before the bond’s maturity.Bermudan option: There are multiple call dates before the bond’s maturity.American OptionAmerican OptionAn American option is a type of options contract (call or put) that can be exercised at any time at the holder’s will of the opportunity before the expiration date. It allows the option holder to reap benefits from the security or stock at any time when the safety or supply is favorable. A European option is the exact opposite of an American option wherein the option holder cannot sell the option until the day of expiration, even when it is favorable. In addition, there is no geographical connection concerning the names since it only refers to the execution of the options trade.read more: All dates before maturity are call dates.

Pricing of Call

The pricing of the bond generally depends on the provisions of the bond structure. The following are the different kinds of pricing.

Fixed regardless of the call datePrice fixed based on a predetermined schedule

Learn more about Options – What are Options in Finance and Options Trading Strategy

The decision of calling a Bond

The issuer decision to call is based on many factors like

Interest rate factors. The company may redeem the bonds with relatively high coupon rates during falling interest rates and replace them with newly issued bonds (commonly called refinancingRefinancingRefinancing is defined as taking a new debt obligation in exchange for an ongoing debt obligation. In other words, it is merely an act of replacing an ongoing debt obligation with a further debt obligation concerning specific terms and conditions like interest rates tenure.read more in vanilla terms). In the case of rising interest rates, issuers have an incentive not to exercise calling bonds at an early date. This may lead to declining bond yields over a term of the investment.Financial factors: If the company has sufficient funds and wants to reduce debt, it may call the bonds back even though interest rates are stable or rising.If the company is thinking of converting debt into equity, it may issue shareIssue ShareShares Issued refers to the number of shares distributed by a company to its shareholders, who range from the general public and insiders to institutional investors. They are recorded as owner’s equity on the Company’s balance sheet.read more in favor of bonds or repay bonds and go for FPO Other factors: There could be many triggers where a company may feel it is beneficial to call the bond.

Valuing the Callable bonds

Generally, the yield is the measure for calculating the worth of a bond in terms of anticipated or projected return. However, there are various measures in calculating the yield.

If the company is thinking of converting debt into equity, it may issue shareIssue ShareShares Issued refers to the number of shares distributed by a company to its shareholders, who range from the general public and insiders to institutional investors. They are recorded as owner’s equity on the Company’s balance sheet.read more in favor of bonds or repay bonds and go for FPO
Current YieldCurrent YieldThe current yield formula essentially calculates the yield on a bond based on the market price instead of face value. The current yield of bond= Annual coupon payment/current market priceread moreYield to maturityYield To MaturityThe yield to maturity refers to the expected returns an investor anticipates after keeping the bond intact till the maturity date. In other words, a bond’s returns are scheduled after making all the payments on time throughout the life of a bond. Unlike current yield, which measures the present value of the bond, the yield to maturity measures the value of the bond at the end of the term of a bond.read moreYield to callYield to worst

Yield to maturity:

YTM is the aggregate total returnTotal ReturnThe term “Total Return” refers to the sum of the difference between the opening and closing value of all the assets over a particular period of time and the returns thereon. To put it simply, the changes in opening and closing values of assets plus the number of returns earned thereof is the Total Return of the entity over a period of time.read more a bond gives if held until maturity. It is always expressed as an annual rate.

YTM is also called a book yield or redemption yield.

A simple method to calculate YTM is as follows

YTM formula = [(Coupon) + {(Maturity Value – Price paid for bond)/(no of years)}] / {(maturity value + price paid for bond)/2}

Let us take an example to understand this a better way

Face value/maturity value of a bond is Rs 1000, No of years of maturity is 10 years, the interest rate is 10%. The price paid to purchase the bond is Rs 920

Numerator = 100+(1000-920)/10

Denominator = (1000+920)/2 = 960

YTM =108/960= 11.25%

This YTM measure is more suitable for analyzing the non-callable bonds as it does not include the impact of call features. So the two additional measures that may provide a more accurate version of bonds are Yield to Call and Yield to worst.

Yield to call

Yield to callYield To CallYield to call is the return on investment for a fixed income holder if the underlying security, such as a callable bond is held until the pre-determined call date rather than the maturity date.read more would be the bond’s yield if you were to buy the callable bond and hold the security until the call exercise date. A calculation is based on the interest rate, time till call date, the bond’s market price, and call priceCall PriceA call price (CP) is the amount an issuer pays the buyer to buyback, call, or redeem a callable security before it matures.read more. Yield to call is generally calculated by assuming that the bond is calculated at the earliest possible date.

For example,

Mr. A owns a bond of GOOGLE company with a face value of Rs. 1000 at a 5% zero-coupon rate. The bond matures in 3 years. This bond is callable in 2 years at 105% of par. In this case, to calculate the bond yield, Mr. A needs to assume that the bond matures in 2 years instead of 3 years. Hence, the call price should be considered at Rs 1050(Rs1000*105%) as principal at maturity.

Let us assume the price paid to buy the bond in the secondary market is Rs 980, then yield to call will be as follows

{Coupon + (call value- price)/time of bond} / {(Face value + price)/2}

Coupon payment is Rs 50 (i.e Rs 1000*5%)

Call value if Rs 1050

Price paid to acquire bond value is Rs 920

Time of bond is 2 years (Assuming call happens in 2 years)

Market price is Rs 980

YTC = [50+(1050-920)/2] (1000+920)/2

= 50+65/960 =12%

Yield to worst

is the lowest yield an investor expects while investing in a callable bond. Generally, callable bonds are good for the issuer and bad for the bondholder. This is because when interest rates fall, the issuer chooses to call the bonds and refinance its debt at a lower rate leaving the investor to find a new place to invest.

Soo, in this case, yield to worst, is very important for those who want to know the minimum they can get from their bond instruments.

Please note that ‘Yield to worst’ is always lower than ‘Yield to maturity’

For example, A bond matures in 10 years, and yield to maturity(YTM) is 4 %. The bond has a call provision where the issuer can call bonds in five years. The yield calculated assuming that the bond matures on call date (YTC) is 3.2%. In this case, the yield to worst is 3.2%

Also, check out Bond PricingBond PricingThe bond pricing formula calculates the present value of the probable future cash flows, which include coupon payments and the par value, which is the redemption amount at maturity. The yield to maturity (YTM) refers to the rate of interest used to discount future cash flows.read more

Now let us look at the Opposite of Callable Bond – Puttable Bond

Puttable bonds

It is a bond with an embedded put optionPut OptionPut Option is a financial instrument that gives the buyer the right to sell the option anytime before the date of contract expiration at a pre-specified price called strike price. It protects the underlying asset from any downfall of the underlying asset anticipated.read more where the bondholder has a Right but not the obligation to demand the principal amount early. The put option can be exercisable on one or more dates.In the case of the rising interest rate scenario, investors sell the bond back to the issuer and lend somewhere else at a higher rate.It is opposite to the callable bond.The price of the puttable bond is always higher than the straight bond as there is a put option which is an added advantage to the investor.However, the yields on the puttable bond are lesser than the yield on a straight bond.

What is a Callable bond?#

Features#

Example#

Purpose of issuing a callable bond#

Should we buy such bonds?#

Structuring of Call Options#

Timing of Call#

Pricing of Call#

The decision of calling a Bond#

Valuing the Callable bonds#

Yield to maturity:#

Yield to call#

Yield to worst#

Puttable bonds#

Recommended Articles#