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.
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.
Academic Research on Callable security
- Robust optimization models for managingcallablebond portfolios Vassiadou-Zeniou, C., & Zenios, S. A. (1996). Robust optimization models for managing callable bond portfolios.European Journal of Operational Research,91(2), 264-273. A major sector of the bond markets is currently represented by instruments with embedded call options. The complexity of bonds with call features, coupled with the recent increase in volatility, has raised the risks as well as the potential rewards for bond holders. These complexities, however, make it difficult for the portfolio manager to evaluate individual securities and their associated risks in order to successfully construct bond portfolios. Traditional bond portfolio management methods are inadequate, particularly when interest-rate-dependent cashflows are involved. In this paper we integrate traditional simulation models for bond pricing with recent developments inrobust optimizationto develop tools for the management of portfolios of callable bonds. Two models are developed: a single-period model that imposes robustness by penalizing downside tracking error, and a multi-stage stochastic program with recourse. Both models are applied to create a portfolio to track a callable bond index. The models are backtested using ex poste market data over the period from January 1992 to March 1993, and they perform constistently well.
- A model for designingcallablebonds and its solution using tabu search Consiglio, A., & Zenios, S. A. (1997). A model for designing callable bonds and its solution using tabu search.Journal of Economic Dynamics and Control,21(8-9), 1445-1470. We formulate the problem of designing callable bonds as a non-linear, global, optimization problem. The data of the model are obtained from simulations of holding-period returns of a given bond design, which are used to compute a certainty equivalent return, viz., some target assets. The design specifications of the callable bond are then adjusted so that the certainty equivalent return is maximized. The resulting problem is multi-modal, and atabu search procedure, implemented on a distributed network of workstations, is used to optimize the bond design. The model is compared with the classical portfolio immunization model, and the tabu search solution technique is compared with simulated annealing for solving the global optimization program. It is shown that the global optimization model yields higher returns than portfolio immunization. It is also shown that tabu search is computationally more efficient than simulated annealing in solving the model, and it produces better solutions.
- Savings bonds, retractable bonds andcallablebonds Brennan, M. J., & Schwartz, E. S. (1977). Savings bonds, retractable bonds and callable bonds.Journal of Financial Economics,5(1), 67-88. Savings bonds, retractable bonds and callable bonds are each equivalent to a straight bond with an option. Neglecting default risk the value of these contingent claims depends upon the riskless interest rate. This paper employs the option pricing framework to value these bonds, under the assumptions that the interest rate follows a Gauss-Wiener process and that the pure expectations hypothesis holds.
- Callablebonds: A riskreducing signalling mechanismRobbins, E. H., & Schatzberg, J. D. (1986). Callable bonds: A riskreducing signalling mechanism.The Journal of Finance,41(4), 935-949. The theory of financial economics has failed to distinguish advantages of callable bonds from those of shortterm debt. This paper shows that either type of borrowing can signal a firm's better prospects but that shortterm debt does so at the cost of weakened risksharing with capital markets. By issuing either equity or longterm, noncallable debt, a firm with poor investment opportunities will not pool its prospects with those of a better firm. But equity produces superior risksharing. Perhaps this explains the almost complete absence of longterm, noncallable bonds from observed corporate capital structures.
- Are negative option prices possible? ThecallableUS Treasury-Bond puzzle Longstaff, F. A. (1992). Are negative option prices possible? The callable US Treasury-Bond puzzle.Journal of Business, 571-592. Market prices for callable Treasury bonds often imply negative values for the implicit call option. I consider a variety of possible explanations for these negative values including the Treasury's track record in calling bonds optimally, tax-related effects, tax-timing options, and bond liquidity. None of these factors accounts for the negative values. Although the costs of short selling may explain why these apparent arbitrage opportunities persist over time, why these implicit call values become negative in the first place remains a puzzle.