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Callable Bond (Redeemable bond) Definition
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.
A Little More on What is a Callable Bond
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 bond’s 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.
References for Redeemable Bond
Academic Research on Callable Bonds
Redeemable corporate securities, Jones, P. W. (1931). S. Cal. L. Rev., 5, 83. This paper illustrates how it is common practice to insert some form of redemption in most corporate bonds. It also explains the effort that has been used in devising, enlarging and refining the language that appears in successive redemption provisions. It also states that these efforts have been fruitful in adjusting the rights of the interested parties without disputes that lead to litigation.
Self-financing in labor-managed firms (lmfs): individual capital accounts and bonds, Tortia, E. C. (2007). In Cooperative firms in global markets (pp. 233-261). Emerald Group Publishing Limited. This paper suggests the introduction of cooperative bonds that would provide a better match between the horizons of members and their firms. However, the bonds generate their risks and therefore require the imposition of various constraints and the retention of appropriate levels of collective reserves. The paper also suggests a hierarchy of liabilities to protect parties who face information disadvantages.
Industry Hallmarks: Conflicted Management and Redeemable Securities, Freeman, J. P. (2007). Journal of Corporation Law, 32(4), 746. This article explains that companies are internally managed since managers are full-time employees who work to benefit the company’s owners and not their own. It also states that funds also have trustees, but investment management and marketing fund shares the fund industry opts for external management of the enterprise.
Yields on redeemable securities subject to capital gains tax, Bizley, M. T. L. (1965). Journal of the Staple Inn Actuarial Society, 17(6), 551-554. This study has a purpose of demonstrating various relationships between the yield ignoring tax and the yield net where the tax rate payable on interest payments is supposed to be the same as the one payable on the capital gain. Otherwise, the concept of a grossed-up net yield is deemed as ambiguous and meaningless.
Accounting for redeemable preferred stock: Unresolved issues, Nair, R. D., Rittenberg, L. E., & Weygandt, J. J. (1990). Accounting Horizons, 4(2), 33. This paper explains that since 1979, the FASB has completed work on a significant portion of the conceptual framework and has presented definitions of the elements of financial statements. The definitions can be utilized to deal with the issue of whether the securities are liabilities and also to address important income statement issues associated with a redeemable preferred stock like accounting for dividends.
Developing the market for corporate bonds in India, Khanna, V., & Varottil, U. (2012). This article determines the elements of an appropriate legal framework that underlies a liquid and vibrant corporate bonds market. This paper argues the weaknesses of these elements in India leads to legal impediments that prevent the smooth operation of the bonds market in India. As a result, the article suggests that any reform process has to address these legal obstacles.
Stochastic inflation and government provision of indexed bonds, Peled, D. (1985). Journal of Monetary Economics, 15(3), 291-308. This research investigates the effects of using indexed bonds as one of the government financing instruments alongside money and taxes. It explains that increasing the share of indexed bonds in the government portfolio increases the volatility and the conditional mean of real rates of return on money.
The Mills Ratio and the behavior of redeemable bond prices in the Gaussian structural model of corporate default, Spencer, P. (2014). Finance Research Letters, 11(1), 8-15. The article indicates that the forward default intensities in the Black and Cox model of corporate default can be expressed in the context of the Mills Ratio. It analyzes the effect of the firm’s distance to default, growth, and volatility on the value of its debt. The results can be utilized to analyze the comparative static properties of other models of corporate default and other first passage time models.
Cost of capital of Islamic banking institutions: an empirical study of a special case, Shubber, K., & Alzafiri, E. (2008). International Journal of Islamic and Middle Eastern Finance and Management, 1(1), 10-19. The primary objective of this study is to determine how calculating the cost of capital for Islamic banks may be different from the conventional ones. To test this hypothesis, the study analyzes the published accounts of four central Islamic banks. It performed this by the help of two surveys, one for banking officials and the other for depositors at a major Islamic bank.
Lottery bonds in France and in the principal countries of Europe, Lévy-Ullmann, H. (1896). Harvard Law Review, 9(6), 386-405. This paper explains that lottery bonds are very similar to ordinary bonds. They are only distinguished by the different use of numbers between these two classes of obligations. The number of issues in the ordinary bond facilitate the redemption of the amount loaned. In the lottery bond, the number of issues printed on the instrument is primarily the number of a lottery ticket.
Performance bonds and guarantees: Construction owners and professionals beware, Ndekugri, I. (1999). Journal of construction engineering and management, 125(6), 428-436. The purpose of this research is identifying the issues that are most common in dispute and the legal principles that govern their resolution. It defines the principles that govern the resolution of these issues. It pays particular attention to any ambiguity whether a surety is liable is always constructed in the surety’s favor.
The proper treatment of premiums and discounts on bonds, May, G. O. (1906). Journal of Accountancy (pre-1986), 2(000003), 174. This paper considers the simplest case of bonds redeemable at par at a fixed date since the same principals can be applied in the more complex cases. The paper is not intended to deal with the mathematical aspect of the concept and uses the necessary formulas to explain what is meant by a premium or discount.