Callable Bond

<body onLoad="MM_checkPlugin('Shockwave Flash','','http://www.riskglossary.com/default_nofl.htm',false);return document.MM_returnValue" stylesrc="../_private/template.htm" bgcolor="#FFFFFF" link="#669933" vlink="#000000" alink="#000000"> <div align="left"> <table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" id="table1"> <tr> <td width="740"> <table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" height="37" id="table2"> <tr> <td height="35" width="100%"> <table border="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" cellpadding="0" id="table3"> <tr> <td width="100%" align="left" valign="top"> <p class="header_gold">Callable Bond</td> <td width="45" align="right" valign="bottom"> <map name="FPMap6"> <area href="http://www.contingencyanalysis.com" shape="rect" coords="1, 0, 44, 11" target="_top"> </map> <img border="0" src="../images/home.gif" usemap="#FPMap6" width="45" height="12"></td> </tr> </table> </td> </tr> <tr> <td width="100%" bgcolor="#CC9966" height="2"> <img border="0" src="../images/blank_2x2.gif" width="2" height="2"></td> </tr> <tr> <td width="0%" valign="top" bgcolor="#FFFFCC"> <table border="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" cellpadding="0" cellspacing="1" id="table4"> <tr> <td width="0%" align="left" valign="top"> <p class="header2_black">Explained:<br> <img border="0" src="../images/blank_1x100.gif" width="100" height="1"></td> <td width="0%" align="left" valign="top"><p class="word_list"> <a href="#callable bond">callable bond</a><p class="word_list"> <a href="#redeemable bond">redeemable bond</a><p class="word_list"> <a href="#refunding">refunding</a><br> <img border="0" src="../images/blank_1x160.gif" width="160" height="1"></td> <td width="100%" align="left" valign="top"> </td> </tr> </table> </td> </tr> </table> <table border="0" cellpadding="0" style="border-collapse: collapse" bordercolor="#111111" width="310" align="right" id="table5"> <tr> <td align="right" width="9" height="14"></td> <td width="300" height="14"> <font size="2"> </font><font size="4"> </font></td> </tr> <tr> <td align="right" width="9"> </td> <td width="300"> <script type="text/javascript"></script> <script type="text/javascript" src="http://pagead2.googlesyndication.com/pagead/show_ads.js"> </script>  </td> </tr> </table> <p style="margin-bottom: 24; margin-top:16" class="body">A <b><a name="callable bond">callable bond</a></b> (or <b><a name="redeemable bond">redeemable bond</a></b>) is a <a href="../articles/coupon_bond.htm">bond</a> whose <a href="../articles/coupon_bond.htm"> indenture</a> includes one or more <a href="../articles/callable_security.htm">call provisions</a> providing for the early retirement ("call" or "redemption") of the bond. Call provisions may provide for <a href="../articles/callable_security.htm">optional redemption</a>, <a href="../articles/callable_security.htm">extraordinary redemption</a> or <a href="../articles/callable_security.htm">sinking fund redemption</a>. 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.</p> <p style="margin-bottom: 24; margin-top:16" class="body">Such callable bonds are especially popular in the United States, where <a href="../articles/corporate_bond.htm">corporate bonds</a> and <a href="../articles/municipal_securities.htm">municipal bonds</a> are often callable. US <a href="../articles/treasury_securities.htm">Treasuries</a> generally are not callable. Most callable bonds are <a href="../articles/coupon_bond.htm">coupon bonds</a>. <a href="../articles/convertible_security.htm">Convertible bonds</a> are often callable. <a href="../articles/zero_coupon_bond.htm">Zero-coupon bonds</a> sometimes are.</p> <p style="margin-bottom: 24; margin-top:16" class="body">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 <a href="../articles/collateral.htm">collateral</a>. 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 <b> <a name="refunding">refunding</a></b>. It benefits the issuer, but investors are forced to surrender their high-coupon bonds and reinvest in the lower interest rate environment.</p> <table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="165" align="left" id="table6"> <tr> <td width="160"> <script type="text/javascript"></script> <script type="text/javascript" src="http://pagead2.googlesyndication.com/pagead/show_ads.js"> </script> </td> <td width="11"> </td> </tr> </table> <p style="margin-bottom: 24; margin-top:16" class="body">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 <a href="../articles/callable_security.htm">first call date</a> has passed, the bond's <a href="../articles/bond_accrued_interest.htm">clean price</a> won't generally rise above the <a href="../articles/callable_security.htm">call price</a>. As is apparent in Exhibit 1, callable bonds tend to have a shorter <a href="../articles/duration_and_convexity.htm"> duration</a> and lower <a href="../articles/duration_and_convexity.htm">convexity</a> than do comparable non-callable bonds.</p> <div align="center"> <center> <table border="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="375" cellpadding="0" id="table7"> <tr> <td> <p class="exhibit_header"><span class="exhibit_header">Price Sensitivity of a Callable Bond</span><br> <span class="exhibit_subheader">Exhibit 1</span></td> </tr> <tr> <td bgcolor="#CC9966" height="2"> <img border="0" src="../images/blank_2x2.gif" width="2" height="2"></td> </tr> <tr> <td> <img border="0" src="../images/ex1_callable_bond.gif" width="350" height="215"></td> </tr> <tr> <td> <p class="exhibit_legend">The price behavior of a callable bond is compared with that of a similar non-callable bond. As interest rates drop, their prices diverge, reflecting the fact that the callable bond is likely to be called.</td> </tr> </table> </center> </div> <p style="margin-bottom: 24; margin-top:16" class="body">A callable bond can be thought of a non-callable bond bundled with a <a href="../articles/short_sale.htm">short</a> <a href="../articles/option.htm">call option</a> on that non-callable bond:</p> <table border="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" cellpadding="0" height="36" id="table8"> <tr> <td width="100%" align="center"> callable bond  =  non-callable bond – call option</td> <td width="5%" align="right">[1]</td> </tr> </table> <p style="margin-bottom: 24; margin-top:16" class="body">The bond holder is short the call option, and the issuer is <a href="../articles/short_sale.htm">long</a> the call option. The option has economic value, so the issuer compensates investors with a higher <a href="../articles/yield.htm">nominal yield</a> than would be payable on a comparable non-callable bond. That higher yield is like an <a href="../articles/time_value_and_intrinsic_value.htm">option premium</a> the issuer pays the bond holder for the call option.</p> <p style="margin-bottom: 24; margin-top:16" class="body">The bundled short call option makes callable bonds very difficult to analyze. The <a href="../articles/yield.htm">yield</a> on a non-callable bond depends upon interest rates and the issuer's <a href="../articles/credit_risk.htm">credit quality</a>. 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 <a href="../articles/callable_security.htm">call protection</a>, <a href="../articles/callable_security.htm">call schedules</a> and the degree to which the call options are <a href="../articles/time_value_and_intrinsic_value.htm">in-the-money</a> or <a href="../articles/time_value_and_intrinsic_value.htm">out-of-the-money</a>. Further complicating matters, the value of the call option depends on the <a href="../articles/volatility.htm">volatility</a> of interest rates, which can change unpredictably.</p> <table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="345" align="right" id="table9"> <tr> <td align="right" width="9"> </td> <td width="336"> <script type="text/javascript"></script> <script type="text/javascript" src="http://pagead2.googlesyndication.com/pagead/show_ads.js"> </script>  </td> </tr> </table> <p style="margin-bottom: 24; margin-top:16" class="body">There is also the question of what <a href="../articles/risk_metric_and_risk_measure.htm">metric</a> of yield to consider when comparing bonds. <a href="../articles/yield.htm">Nominal yield</a> and <a href="../articles/yield.htm">current yield</a> are problematic with any bond. While <a href="../articles/yield.htm">yield to maturity</a> is useful for comparing non-callable bonds, it is somewhat meaningless for callable bonds—which may be called long before they mature. Yield metrics designed specifically for callable bonds—such as <a href="../articles/yield.htm">yield to first call</a> or <a href="../articles/yield.htm">yield to worst</a>—offer an indicating of value that is crude at best.</p> <p style="margin-bottom: 24; margin-top:16" class="body">Sophisticated analysis of callable bonds requires the use of <a href="../articles/option_pricing_theory.htm">financial engineering</a> techniques that simultaneously value the <a href="../articles/credit_risk.htm">credit risk</a>, <a href="../articles/interest_rate_risk.htm">interest rate risk</a> and optionality of a callable bond. 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