Bonds & Interest Rates4 分で読めます

Callable Bonds (Redeemable at the Issuer's Option)

If someone you lent money to says 'I'll stop repaying now' and returns your principal before maturity, is that only a good thing? With a callable bond, exactly that happens.

What is a callable bond

A callable bond is a bond with a right (a call provision) that lets the issuer repay the principal early before the set maturity.

The terms of this right (from when, and at what price it can be repaid) are written in advance in the bond's contract (the indenture). Corporate bonds and many agency and government-related bonds carry such call provisions.

The key point is that 'the option belongs to the issuer.' The investor cannot refuse this early redemption.

Source: Britannica Money (Callable Bonds), Wall Street Prep. A call provision is the issuer's right to redeem the principal before maturity.

When will the issuer exercise the call

The typical situation in which an issuer redeems early is 'when market rates have fallen.'

For example, suppose a company issued a bond at 5% a year, and afterward market rates fell to 3%. From the issuer's standpoint, it's advantageous to repay the expensive 5% bond and issue a new 3% bond. It's similar to refinancing a loan.

The problem is that this works in reverse for the investor. Just when you expected to keep receiving the nice 5% interest, you get your principal back at exactly the point when rates have fallen.

Call premium and reinvestment risk

The extra amount an issuer pays on top of face value when redeeming early is called the call premium. It's a device that partly compensates for the interest and reinvestment burden the investor loses from early redemption. This premium shrinks as maturity approaches and eventually converges to face value.

But the premium doesn't compensate for everything. This is where reinvestment risk arises. When you try to put the repaid principal back to work, rates have already fallen, making it hard to find products on terms as good as before.

In other words, a callable bond has an asymmetric structure where 'when rates fall the good bonds get recalled, and when rates rise only the bad bonds are left in your hands.'

Source: Corporate Finance Institute (call risk), efinancemanagement. The call premium is meant to compensate for the interest lost and the reinvestment risk from early redemption.

You should look at YTC, not YTM

For an ordinary bond, you judge its appeal by yield to maturity (YTM), the return if held to maturity.

But a callable bond may not make it to maturity. So you should also look at the yield to call (YTC), the return if held until the call date.

When rates are low and the likelihood of a call rises, the return you actually pocket approaches the lower YTC rather than the YTM. So conservatively, people often judge based on the lower of YTM and YTC (the yield to worst, YTW). If you judge by the coupon rate alone and think 'the interest is high,' you easily miss the call risk.

Source: Britannica Money, Wall Street Prep. When the likelihood of a call is high, the yield to worst (YTW) becomes the YTC.

よくある質問

Q. Why do callable bonds pay a bit more interest?

Because the investor takes on the 'risk of being redeemed early.' Since a call right favorable to the issuer is attached, callable bonds tend to pay a slightly higher coupon rate than an ordinary bond on the same terms, to compensate for that risk. But high interest means you're taking on that much call risk and reinvestment risk; it's not given for free.

Q. Do I take a loss if it's redeemed early?

You get back the principal and the call premium, so you don't lose principal right away. The real loss is in the 'opportunity.' Because issuers usually exercise the call when rates have fallen, it's hard to reinvest the returned money at rates as good as before. This is reinvestment risk, a cost that doesn't show up clearly on the surface.