Definition
Callable refers to a feature in certain securities, most commonly bonds, that allows the issuer to redeem the security before its scheduled maturity date. When a security is called, the issuer pays the holders a premium price, known as a call premium. Issuers typically call bonds when interest rates have fallen, allowing them to issue new bonds at a lower interest rate and economize on interest payments.
Examples
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Callable Bonds: A company issues 30-year bonds with a callable feature after 10 years. If interest rates drop significantly in those 10 years, the company can call the bonds, pay off the holders with a call premium, and reissue new bonds at the current lower interest rates.
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Mortgage-Backed Securities (MBS): A MBS may also have a callable feature. If homeowners prepay their mortgages due to refinancing at lower rates, the MBS could be called, returning principal to investors alongside a potential premium.
Frequently Asked Questions (FAQs)
1. Why would an issuer want to call a bond?
Issuers call bonds to take advantage of lower interest rates, thus saving on interest payments by refinancing the debt at a reduced rate.
2. What is a call premium?
A call premium is the extra amount over the face value that issuers pay bondholders when the bond is called before maturity. This acts as compensation for the early redemption.
3. Are callable bonds more risky for investors?
Yes, because if a bond is called, the investor may be forced to reinvest the principal at a lower interest rate, leading to a potential decrease in total returns.
4. How is the call price determined?
The call price is typically set at issuance and includes the face value of the security plus a call premium.
5. Can all bonds be called?
No, only bonds and securities issued with an explicit callable feature can be called by the issuer before the end of the maturity period.
- Call Premium: The additional amount paid by the issuer over the bond’s face value when the bond is called early.
- Call Price: The total amount (face value plus call premium) paid to the bondholder by the issuer upon calling the bond before its maturity.
- Convertible Bond: A bond that can be converted into a predefined amount of the issuer’s equity at certain times during the bond’s life.
Online References
- Investopedia on Callable Bonds
- Wikipedia on Callable Bonds
- Securities and Exchange Commission (SEC) definition of Callable Bonds
Suggested Books for Further Studies
- The Bond Book by Annette Thau - A comprehensive guide to understanding bonds.
- Fixed Income Securities: Tools for Today’s Markets by Bruce Tuckman and Angel Serrat.
- Investing in Bonds For Dummies by Russell Wild - An easy-to-understand primer on bond investing.
Fundamentals of Callable: Finance Basics Quiz
### What does the term 'callable' mean in the context of bonds?
- [x] The issuer has the right to redeem the bond before its maturity.
- [ ] The bondholder can demand early redemption from the issuer.
- [ ] The bond cannot be redeemed before maturity.
- [ ] The issuer must buy back the bond within one year.
> **Explanation:** A callable bond allows the issuer to redeem the bond before its scheduled maturity date, typically upon paying a call premium.
### Why might an issuer call a bond?
- [ ] Interest rates have increased.
- [x] Interest rates have decreased.
- [ ] The issuer is in financial trouble.
- [ ] Bondholders have demanded it.
> **Explanation:** Issuers call bonds when interest rates fall so that they can reissue new bonds at lower interest rates and reduce their debt servicing costs.
### What is a call premium?
- [ ] A penalty paid by the bondholder.
- [x] An additional payment over the face value paid by the issuer to call the bond.
- [ ] The face value of the bond.
- [ ] The accrued interest on the bond.
> **Explanation:** A call premium is the extra amount issuers pay bondholders to redeem a bond before its maturity, compensating them for the early call.
### How is the call price calculated?
- [x] Face value plus the call premium.
- [ ] Face value minus the call premium.
- [ ] Only the face value.
- [ ] Twice the face value.
> **Explanation:** The call price is determined by adding the face value of the bond and the call premium.
### Can all bonds be called?
- [ ] Yes, all bonds are callable.
- [ ] No bonds are callable.
- [x] Only bonds issued with a callable feature can be called.
- [ ] Only municipal bonds are callable.
> **Explanation:** Only bonds that are issued with a callable feature explicitly in their terms can be called by the issuer before maturity.
### Are callable bonds more or less risky for investors than non-callable bonds?
- [ ] Less risky.
- [x] More risky.
- [ ] Equally risky.
- [ ] Not risky at all.
> **Explanation:** Callable bonds are more risky because the bondholder is subject to reinvestment risk if the bond is called early, likely at a lower interest rate.
### What happens to interest payments if a bond is called early?
- [x] Interest payments stop since the bond is redeemed.
- [ ] Interest payments continue until the original maturity date.
- [ ] Interest payments are accelerated.
- [ ] The coupon rate increases.
> **Explanation:** When a bond is called, it is redeemed and interest payments stop.
### What type of market condition typically prompts issuers to call bonds?
- [ ] Rising stock prices.
- [ ] Rising commodity prices.
- [x] Falling interest rates.
- [ ] Increasing inflation.
> **Explanation:** Falling interest rates prompt issuers to call bonds so they can reissue new bonds at lower interest rates and reduce their cost of interest payments.
### Is the call premium fixed or variable?
- [x] Fixed at the time of issuance.
- [ ] Variable based on market conditions.
- [ ] Determined by the bondholder.
- [ ] Optional for the issuer.
> **Explanation:** The call premium is typically fixed at the time the bond is issued.
### How does the callable feature impact the yield of a bond?
- [x] It may increase the yield to compensate for additional risk.
- [ ] It decreases the yield since the bond can be called.
- [ ] It has no effect on the yield.
- [ ] It guarantees the highest yield in the market.
> **Explanation:** Callable bonds may offer higher yields to investors to compensate for the risk that the bond might be called before maturity.
Thank you for studying the concept of callable securities with our comprehensive guide and engaging quiz! Keep enhancing your financial literacy for greater investment acumen!
