Callable bonds: living a double life

Generally, bonds are a very simple investment tool. It pays interest before maturity and has a single, fixed life. It is predictable, simple and safe. On the other hand, callable bonds can be regarded as the exciting and slightly dangerous cousins ​​of standard bonds.

Callable bonds have a “double life”. They are more complex than standard bonds and require more attention from investors. In this article, we will study the difference between standard bonds and callable bonds. Then we explore whether callable bonds are suitable for your investment portfolio.

Key points

  • The issuer can call back the callable bonds before the maturity date, making it more risky than non-callable bonds.
  • However, callable bonds compensate investors for the high risk by offering slightly higher interest rates.
  • Callable bonds face the risk of reinvestment, that is, if the bond is redeemed, investors will have to reinvest at a lower interest rate.
  • When interest rates remain the same, callable bonds are a good investment.

Callable bonds and double life

Callable bonds have two potential life cycles, one ends on the original maturity date and the other ends on the redemption date.

On the redemption day, the issuer can recall the bonds to investors. This simply means that the issuer returns (or repays) the bonds by returning investors’ funds. Whether this happens depends on the interest rate environment.

Consider the example of the issuance of a 30-year redeemable bond, which has a coupon rate of 7% and is redeemable after five years. Suppose the interest rate on the new 30-year bond is 5% after 5 years. In this case, the issuer may recall the bond because the debt can be refinanced at a lower interest rate. Instead, assume that the interest rate rises to 10%. In this case, the issuer does nothing because bonds are relatively cheap compared to market interest rates.

In essence, callable bonds represent standard bonds, but with embedded call options. The option is implicitly sold to the issuer by the investor. It gives the issuer the right to return the bond after a certain point in time. In short, the issuer has the right to “recover” the bond from the investor, so it is called a callable bond. This option brings uncertainty to the life of the bond.

Redeemable bond compensation

In order to compensate investors for this uncertainty, the issuer will pay a slightly higher interest rate than the interest rate required for similar non-callable bonds. In addition, the issuer may issue redeemable bonds at a price higher than the original face value. For example, a bond may be issued at a face value of US$1,000 but be called back at US$1,050. The issuer’s cost is represented by the overall higher interest cost, while the investor’s benefit is the overall higher interest.

Although the issuer’s cost is higher and the investor’s risk is higher, these bonds are very attractive to any party. Investors like them because their returns are higher than normal, at least until the bonds are cancelled. On the contrary, callable bonds are attractive to issuers because they allow them to reduce interest costs when interest rates fall in the future. In addition, they play an important role in financial markets by creating opportunities for companies and individuals to act in accordance with their interest rate expectations.

Overall, callable bonds also provide investors with a major advantage. Since there is no guarantee that interest payments will be received during the entire period, their demand is small. Therefore, issuers must pay higher interest rates to persuade people to invest in them. Usually, when investors want higher-interest bonds, they have to pay a bond premium, which means they pay more than the face value of the bond. However, with callable bonds, investors do not need to pay bond premiums to get higher interest payments. Callable bonds are not always redeemed. Many of them end up paying interest for the entire term, and investors always benefit from higher interest.

Higher risk usually means higher investment returns, and callable bonds are another example of this phenomenon.

Take a look before you get into callable bonds

Before investing in redeemable bonds, investors must understand these tools. In addition to standard bonds, they also introduce a new set of risk factors and considerations. Understanding the difference between yield to maturity (YTM) and yield to maturity (YTC) is the first step in this regard.

Standard bonds are quoted based on their YTM, which is the expected rate of return on bond interest payments and final capital returns. YTC is similar, but only considers the expected rate of return when the bond is redeemed. The risk that bonds may be called back brings another major risk to investors: reinvestment risk.

An example of reinvestment risk

Although reinvestment risk is simple and easy to understand, its impact is far-reaching. For example, consider two 30-year bonds issued by companies with the same good reputation. Suppose Company A issues standard bonds with YTM of 7%, and Company B issues redeemable bonds with YTM of 7.5% and YTC of 8%. On the surface, due to higher YTM and YTC, Company B’s callable bonds seem more attractive.

Now, assuming that interest rates fall within five years, Company B can issue standard 30-year bonds at only 3%. What will the company do? It is likely to recall its bonds and issue new bonds at lower interest rates. Those who invested in the redeemable bonds of Company B will now be forced to reinvest their capital at a much lower interest rate.

In this example, they might best buy company A’s standard bonds and hold them for 30 years. On the other hand, if interest rates remain the same or increase, investors will benefit from company B’s redeemable bonds.

Different reactions to interest rates

In addition to reinvestment interest rate risk, investors must also understand that the market price of callable bonds differs from the performance of standard bonds. Usually, you will see bond prices rise as interest rates fall. However, this is not the case with callable bonds. This phenomenon is called price compression, and it is an integral part of the behavior of callable bonds.

Since the lifespan of standard bonds is fixed, investors can assume that interest payments will continue until the maturity date and appropriately evaluate these payments. Therefore, as interest rates fall, interest payments become more valuable, and therefore bond prices rise.

However, since the callable bonds can be called back, these future interest payments are uncertain. The more interest rates fall, the less likely it is that interest will be paid in the future as the issuer’s likelihood of redemption of the bond increases. Therefore, the upward price appreciation of redeemable bonds is usually restricted, which is another trade-off for obtaining higher than normal interest rates from the issuer.

Are redeemable bonds a good addition to the portfolio?

Like any investment vehicle, callable bonds have a place in a diversified investment portfolio. However, investors must keep in mind its unique qualities and form appropriate expectations.

There is no free lunch in the world, and the higher interest earned by redeemable bonds comes at the expense of the risk of reinvestment rate and the potential for price appreciation. However, these risks are related to falling interest rates. This makes callable bonds one of many tools for investors to express their tactical views on the financial market and achieve optimal asset allocation.

Bet on interest rates when choosing callable bonds

The effective tactical use of callable bonds depends on people’s perception of future interest rates. Remember that callable bonds consist of two main components, namely standard bonds and embedded interest rate call options.

As a bond buyer, you are basically betting that the interest rate will remain the same or increase. If this happens, you will benefit from higher than normal interest rates for the entire duration of the bond. In this case, the issuer will never have the opportunity to recall the bond and reissue the debt at a lower interest rate.

Conversely, if interest rates fall, the appreciation of your bonds will be lower than standard bonds and may even be cancelled. If this happens, you will benefit from higher interest rates in the short term. However, you will have to reinvest your assets at a lower prevailing interest rate.

Bottom line

As a general rule of thumb for investing, it is best to diversify your assets as much as possible. Callable bonds are a tool to increase the rate of return on fixed-income investment portfolios. On the other hand, they do so with additional risks and represent a bet on lower interest rates. In the long run, those attractive short-term yields may eventually cost investors.

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