A redeemable debt, or callable debt, is a bond that an issuer can repay before its maturity. The issuer usually pays a premium to the investor when a debt is redeemed. The borrower generally has to pay a premium or fee to the holder of bonds on debt redemption.
A callable bond helps the organization to scale back the value of funding in operating activities. It allows companies to pay off their debt early and luxuriate in a favorable rate of interest drops. A callable bond benefits the issuer and the investor, as investors of these bonds are compensated with a more attractive rate of interest than on otherwise similar non-callable bonds.
To explain, say, an issuer redeems all bonds with an 8% interest rate when the market rate averages at 4%. To issue such debt, a company hires an investment advisor or a specialist in corporate finance to get insight into economic trends and advise about the suitable timings for issuance of redeemable debt.
Advantages and Disadvantages of Redeemable Debt to Issuers and Investors
Callable bonds come with a great advantage for investors in terms of high returns. Due to the lack of assurance of receiving interest payments for the complete term, they are less in demand, so issuers must pay higher interest rates to encourage investors to invest in them.
Usually, a bond with a higher interest rate comes with a significant premium paid by investors, meaning they pay more than the nominal value. A callable bond, however, allows the investor to receive higher interest payments without a bond premium.
Callable debt is not always called; many of them continue for the full term, and the investor earns the benefits of higher yield for the entire duration. Moreover, they serve an essential purpose for financial markets by creating opportunities for companies and individuals to act upon their interest-rate expectations. The terms of the bond’s offering specify the time when the company may redeem the note.
Reinvestment risk is profound in its implications. For example, consider two 20-year bonds issued by similarly credit-worthy companies. Assume Company 1 issues a regular bond with a Yield to Maturity of 5%, and Company 2 issues a callable bond with a Yield to Maturity of 6% and a Yield to Call of 7%.
Company 2’s callable bond seems most attractive on the surface due to the higher Yield to Maturity and Yield To Call. Now, assume interest rates decrease in three years so that Company 2 could issue a standard 20-year bond at only 4%. What would such a company do?
It would most likely recall its existing bonds and issue new bonds at the reduced interest rate. People that invested in Company 2’s callable bonds would now be forced to reinvest their money at much lesser interest rates.
This bond is typically called at a slightly higher value than the par value of the debt to soften up the call. The earlier the bond’s life span is, the higher will be its call value. For example, a bond maturing in 2025 may be called in before 2025.
It may show a callable price of 105. This price means the investor receives $1,050 for every $1,000 in the nominal value of their investment.
Let’s assume that the bonds mentioned above were issued at an 8% interest rate. Four years from the date of issuance, interest rates fall by 400 basis points (bps) to 4%. This will prompt the company to redeem the bonds.
Under the terms of the bond agreement, if the company calls the bonds, it must pay the investors a $102 premium to par. Therefore, the company pays the bond investors $1020 per bond. It will reissue the bond with a 4% coupon rate reducing its annual interest payment to 4%.
Pros and Cons of Callable Bonds
|Investors get higher coupons or interest rates.||Investors might be required to reinvest in bonds with lower-rate products.|
|Startups use such debt instruments to raise capital quickly when managing finance from other sources is complicated.||Costs to the company are high due to high coupon rates.|
|Call features allow the issuer to recall debt to reduce the finance cost.||Investors cannot take benefit when market rates increase.|
|Investor-financed debt is more beneficial for the issuer than financing from the bank.|
Types of Callable Bonds
- Municipal bonds and few corporate bonds are callable in nature. A municipal bond may be called or exercised after a set period, such as ten years.
- A sinking fund is another type. It requires the issuer to observe a set schedule while redeeming the debt in part or in full. The company will send a fraction of the bond to the holders at a stated date.
The yield of the redeemable bond
The yield on a bond that is redeemable is known interchangeably as yield to maturity (YTM) or redemption yield.
It involves a complex calculation to arrive at the yield on a redeemable bond. The amount of redemption and the time left before maturity also influence the yield. Bond yields are usually tested and calculated at a strategic level, and past remarks of examiners show that students often find the calculations difficult.
The YTM is different from the coupon rate on the bond.
The yield of a redeemable bond is found by calculating the IRR of the bond’s current price, the redemption payment, and the annual interest payments. Where the bond is a foreign currency bond, we have to convert the cash flows to the company’s home currency, using the predicted exchange rates, before the calculation of IRR.