Callable Bonds
What are callable bonds?
Well let's start with this: have you ever refinanced a loan before? If not, do you at least understand what it means?
If so, you have the basic understanding of what these are.
Bonds are simply debt instruments used by corporate or government entities to borrow
money from the investing public. Like any other loan, these bonds have predetermined interest rates that the issuer of
the bond agrees to pay the bondholder over the life of the bond.
Many factors affect the interest rate that is paid to the bondholder, but one of those factors is the interest rate
in the economy at the time the bond is issued. If interest rates are high, then the bond will naturally have a higher
yield (or coupon rate).
Let's say that interest rates in the economy decrease dramatically. This means that the corporation or government
can secure debt at a lower interest rate than it is paying on pre-existing bonds. Therefore an entity may decide to
call the outstanding debts and make all the bond holders whole, and then reissue new bonds at a lower interest rate. In other
words, this is their way of refinancing their debt.
Generally speaking, if your bonds are called, the issuer will "buy" the bonds back at a premium, so your investment
is not entirely lost. Put another way, if an issuer elects to call back bonds on the call date, the call price will
exceed the par value of the bond. Since there is a risk in callable bonds of having the bond called and reissued at a
lower rate, the coupon rate of the bond will generally be higher to compensate for this risk.
