Redeemable Bonds - Explained
What is a Callable Bond?
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Table of ContentsWhat is a Callable Bond?How Does a Redeemable Bond Work?
What is a Callable Bond?
Callable or redeemable bonds can be redeemed or paid off by the issuer before it reaches the date of its maturity. The issuer of such bonds is allowed to pay back its obligation to the bondholder before maturity. The issuer can buy back the bonds by paying the call price together with its accrued interest up to the date (which allows them to stop paying the interest immediately). In effect, the bonds are not actually bought back and kept; rather, it gets canceled and the issuer issues new bonds.
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How Does a Redeemable Bond Work?
Usually, the call price on a bond is higher than the par value. The earlier it is called, the higher is the call price. For example, a bonds maturity date is stated as 2025 and the issuer decides to call it in 2018. If the bond is callable at a price of $105 the investors will get $105 for each $100 in face value. Stipulations say the callable price will go down if the issuer decides to call the bond in 2020. The issuers generally call of a bond when the interest rate on the bond exceeds the current interest rate. Then, the issuer may issue new bonds with a lower interest rate in order to save money. Municipal bonds are mostly callable bonds. Some corporate houses also issue callable bonds. Treasury bonds and notes are usually noncallable with some exceptions. The issuers of callable bonds offer a higher coupon rate to its investors than the noncallable bonds. In return, they ensure their flexibility in payment amount and loan length. If situation demand, they can call off the bonds in order to issue new ones with a lower interest rate. The issuer has a right to call off the bonds before its maturity date, but they are not obliged to do so. If a company decides to collect $20 million from the investors in the bond market and issues a 6% coupon bond and determines its maturity date after 10 years. Then the company has to pay 6% x 20 million = $1,200,000 a year to the bondholders as interest. After six years the interest rate declines to 4%. At this point, the company may redeem the bonds and pay the investors according to the bond terms. Say, they need to pay $102 premium to par. Then the company has to pay $20.4 million to its investors and borrows it from the bank at 4% interest rate. Then they reissue bonds at 4% interest rate with a principal amount of $20.4 million. The annual payment for interest will get reduced to 4% x $20.4 million = $816,000. The investors choose a callable bond for its higher coupon rate although if the bond is called off prior to its maturity most likely the investor will have to invest the amount with a lower interest rate.