Callable Security - Explained
What is a Callable Security?
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Table of ContentsWhat is a Callable Security?How Does a Callable Security Work?Call ProtectionCall DateCall PremiumAcademic Research on Callable security
What is a Callable Security?
A callable security is a security that allows the issuer to redeem or repurchase it at a specified time before its maturity date. This means that the holder of a callable security can have the security repurchased by the issuer before its maturity date. Although, holders of callable security are entitled to high interest rates but also face the risk of the security being redeemed or repurchased before maturity. Issuers of callable bonds or security are not obliged to redeem or repurchase the security, it is just a right they enjoy over the security.
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How Does a Callable Security Work?
Issuers of callable bonds use bonds of this nature as a protective measure to safeguard them from overpaying debt or interest to the bondholder and also reduce their cost of borrowing. Typically, a bondholder is entitled to interest payments until the maturity date of the bond. However, in the case of callable bonds, issuers can redeem them before they mature, and bondholders are exposed to the risk of termination of interest payment once the bond is repurchased or redeemed. Not all securities or bonds have a call provision, this type of provision is often found in fixed-income instruments. Generally, callable securities are less expensive and have higher interest rates.
Call provisions are embedded in the trust indenture of securities, this means before an investor purchases a bond of this nature, the conditions are well established or known. One of the rights that issuers of callable bonds enjoy is the right to repurchase or redeem the bonds before their maturity date. One of the provisions of callable securities is a call protection which gives a bondholder the right to reject a redemption or repurchase of bonds at an early stage. Hence, issuers cannot force a redemption on a callable security when at an early stage. With a call protection, investors can enjoy interest rates on the bonds for a number of years before they are redeemed or repurchased by the issuer.
Every callable security has a call protection, this is the period during which an issuer cannot redeem or repurchase the bond, it is always at the early stage of the bond. Once the call protection elapses, the issuer can exercise the right to call the bond. The call date refers to the period an issuer can redeem or repurchase a callable bond. The call date is included in the trust indenture, it is often the time when the call protection expires. A callable security can have one call date or more than one. When there are many call dates, then the callable security has a series of call dates which are scheduled in the trust indenture. The issuer can choose to redeem the bond on any of the call dates.
A call premium is the compensation that bond issuers pay to bondholders for redeeming or repurchasing the security before the maturity date. Call premium is the amount over the par value of the security, it is the difference between the call price of a bond and its face value. Issuers that decide to exercise their rights of pf calling a callable security before its expiration date are mandated to pay the call premium to the bondholder. Since investors are deprived of the benefit of future income through interest payments on bonds, issuers pay call premium to compensate for risks at the event of redeeming a bond before its maturity.