Question

During the reading of the textbook there is a section about call provision. This is when a corporation has the right to call the bonds for redemption. The book says that that the company must pay the bondholders an amount great than the par value if they are called. They usually do this if interest rates drop. The reason being is that bonds and interest rates have an inverse relationship. After the company calls the bonds they will issue out other bonds at a lower interest rate. Why would investors invest in callable bonds if companies can just call them back (after a certain amount of time) and issue out others bonds with lower interest rates?

Answer 1

Callable bonds have a "double-life," and as such, they are more complex than a normal bond and require more attention from an investor.

Callable bonds have two potential life spans, one ending at the original maturity date and the other at the "callable date."

At the callable date, the issuer may "recall" the bonds from its investors. This simply means the issuer retires (or pays off) the bond by returning the investors' money. Whether or not this occurs is a factor of the interest rateenvironment.

Consider the example of a 30-year callable bond issued with a coupon of 7% that is callable after five years. Assume that five years later interest rates for new 30-year bonds are 5%. In this instance, the issuer would recall the bonds because the debt could be refinanced at a lower interest rate. Conversely, if rates moved to 10% the issuer would do nothing, as the bond is relatively cheap compared to market rates.Essentially, callable bonds represent a normal bond, but with an embedded call option. This option is implicitly sold to the issuer by the investor, and entitles the issuer to retire the bonds after a certain point in time. Put simply, the issuer has the right to "call away" the bonds from the investor, hence the term callable bond. This option introduces uncertainty to the lifespan of the bond.To compensate investors for this uncertainty, an issuer will pay a slightly higher interest rate than would be necessary for a similar, but non-callable bond. Additionally, issuers may offer bonds that are callable at a price in excess of the original par value. For example, the bond may be issued at a par value of $1,000, but be called away at a par value of $1,050. The issuer's cost takes the form of overall higher interest costs, and the investor's benefit is overall higher interest received.

Despite the higher cost to issuers and increased risk to investors, these bonds can be very attractive to either party. Investors like them because they give a higher-than-normal rate of return, at least until the bonds are called away. Conversely, callable bonds are attractive to issuers because they allow them to reduce interest costs at a future date should rates decrease. Moreover, they serve an important purpose to financial markets by creating opportunities for companies and individuals to act upon their interest-rate expectations.

Overall, callable bonds also come with one big advantage for investors. They are less in demand due to the lack of a guarantee of receiving interest payments for the full term, so issuers must pay higher interest rates to persuade people to invest in them. Normally, when an investor wants a bond at a higher interest rate, they must pay a bond premium, meaning that they pay more than the face value for the bond. With a callable bond, however, the investor can receive higher interest payments without a bond premium. Callable bonds do not always get called; many of them pay interest for the full term, and the investor reaps the benefits of higher interest for the entire duration.