Callable Bonds: Leading a Double Life

Normally, a bond is a very simple investment instrument. It pays interest until expiration and has a single, fixed life span. It is predictable, plain, and safe. On the other hand, the callable bond can be seen as the exciting, slightly dangerous cousin of the standard bond.

Callable bonds have a "double life." They are more complex than standard bonds and require more attention from investors. In this article, we'll look at the differences between standard bonds and callable bonds. We then explore whether callable bonds are right for your investment portfolio.

Callable Bonds and the Double Life

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

At the call date, the issuer may recall the bonds from its investors. That simply means the issuer retires (or pays off) the bond by returning the investors' money. Whether or not this occurs depends on the interest rate environment.

Consider the example of a 30-year callable bond issued with a 7% coupon that is callable after five years. Assume that interest rates for new 30-year bonds are 5% five years later. In this instance, the issuer would probably recall the bonds because the debt could be refinanced at a lower interest rate. Conversely, suppose that rates moved to 10%. In that case, the issuer would do nothing because the bond is relatively cheap compared to market rates.

Essentially, callable bonds represent a standard bond, but with an embedded call option. This option is implicitly sold to the issuer by the investor. It 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 life span of the bond.

Callable Bond Compensation

To compensate investors for this uncertainty, an issuer will pay a slightly higher interest rate than would be necessary for a similar noncallable bond. Additionally, issuers may offer bonds that are callable at a price above the original par value. For example, the bond may be issued at a par value of $1,000, but be called away at $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 if rates decrease. Moreover, they serve a valuable purpose in 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. Therefore, issuers must pay higher interest rates to persuade people to invest in them. Usually, 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 end up paying interest for the full term, and the investor reaps the benefits of higher interest the entire time.

Look Before You Leap Into Callable Bonds

Before jumping into an investment in a callable bond, an investor must understand these instruments. They introduce a new set of risk factors and considerations over and above those of standard bonds. Understanding the difference between yield to maturity (YTM) and yield to call (YTC) is the first step in this regard.

Standard bonds are quoted based on their YTM, which is the expected yield of the bond's interest payments and the eventual return of capital. The YTC is similar, but only takes into account the expected rate of return should the bonds get called. The risk that a bond may be called away introduces another significant risk for investors: reinvestment risk.

An Example of Reinvestment Risk

Reinvestment risk, though simple to understand, is profound in its implications. For example, consider two 30-year bonds issued by equally creditworthy firms. Assume Firm A issues a standard bond with a YTM of 7%, and Firm B issues a callable bond with a YTM of 7.5% and a YTC of 8%. On the surface, Firm B's callable bond seems more attractive due to the higher YTM and YTC.

Now, assume interest rates fall in five years so that Firm B could issue a standard 30-year bond at only 3%. What would the firm do? It would most likely recall its bonds and issue new bonds at the lower interest rate. People that invested in Firm B's callable bonds would now be forced to reinvest their capital at much lower interest rates.

In this example, they would likely have been better off buying Firm A's standard bond and holding it for 30 years. On the other hand, the investor would be better off with Firm B's callable bond if rates stayed the same or increased.

A Different Response to Interest Rates

In addition to reinvestment-rate risk, investors must also understand that market prices for callable bonds behave differently than standard bonds. Typically, you will see bond prices increase as interest rates decrease. However, that is not the case for callable bonds. This phenomenon is called price compression, and it is an integral aspect of how callable bonds behave.

Since standard bonds have a fixed life span, investors can assume interest payments will continue until maturity and appropriately value those payments. Therefore, interest payments become more valuable as rates fall, so the bond price goes up.

However, since a callable bond can be called away, those future interest payments are uncertain. The more interest rates fall, the less likely those future interest payments become as the likelihood the issuer will call the bond increases. Therefore, upside price appreciation is generally limited for callable bonds, which is another tradeoff for receiving a higher-than-normal interest rate from the issuer.

Are Callable Bonds a Good Addition to a Portfolio?

As is the case with any investment instrument, callable bonds have a place within a diversified portfolio. However, investors must keep in mind their unique qualities and form appropriate expectations.

There is no free lunch, and the higher interest payments received for a callable bond come at the cost of reinvestment-rate risk and diminished price-appreciation potential. However, these risks are related to decreases in interest rates. That makes callable bonds one of many tools for investors to express their tactical views on financial markets and achieve an optimal asset allocation.

Betting on Interest Rates When Opting for Callable Bonds

Effective tactical use of callable bonds depends on one's view of future interest rates. Keep in mind that a callable bond is composed of two primary components, a standard bond and an embedded call option on interest rates.

As the purchaser of a bond, you are essentially betting that interest rates will remain the same or increase. If this happens, you will benefit from a higher-than-normal interest rate throughout the bond's life. In this case, the issuer would never have an opportunity to recall the bonds and reissue debt at a lower rate.

Conversely, your bond will appreciate less in value than a standard bond if rates fall and might even be called away. Should this happen, you would have benefited in the short term from a higher interest rate. However, you would then have to reinvest your assets at the lower prevailing rates.

The Bottom Line

As a general rule of thumb in investing, it is best to diversify your assets as much as possible. Callable bonds are one tool to enhance the rate of return of a fixed-income portfolio. On the other hand, they do so with additional risk and represent a bet against lower interest rates. Those appealing short-term yields can end up costing investors in the long run.