Callable bonds are a somehow more complex type of bonds. They have unique qualities different from those of normal bonds. Learn more about callable bonds and learn whether it is wise to add them to your portfolio of investments.
The Lifespan of a Callable Bond
Callable bonds basically have two possible lifespans. One of these lifespans end at the supposed maturity date of the bond, and the other ends at the “callable date.”
At the callable date, the bond issuer may ‘recall’ the bonds from the investors who are holding them. What this means is that the issuer retires and pays off the bond by giving back the investors’ invested money. The chances that this may happen depend on the interest rate environment.
Basically, callable bonds are just like normal bonds but with the embedded ‘callable’ feature. This option is implicitly sold to the bond holder and entitles the issuer to retire the bonds after a certain point in time.
Simply put, the issuer has the right to call away the bond from the investor, giving it the name of “callable bond”. This option introduces uncertainty to the life span of the bond.
Compensation
To provide some compensation for investors who take on this risk, the issuer pays a slightly higher interest rate than would be needed for a similar, non-callable bond. On top of that, issuers may provide bonds that are callable at a price in excess of the original par value. The issuer’s cost is in the form of higher interest cost and the investor’s benefit is overall higher interest paid.
In spite of the higher cost on the issuer’s side and higher risks on the investor’s, callable bonds are still in demand for either party. For investors, these bonds pay a rate of return that’s higher than usual, at least before the bonds are finally called away.
Meanwhile, callable bonds are appealing to issuers because they enable them to reduce interest costs at a future date if rates decrease. They also give companies the companies and investors the opportunities to act upon their interest rate expectations.
Further, for investors, callable bonds are less in demand so issuers need to pledge higher interest rates if they want investors to buy them. Usually, when an investor wants a higher interest rate, he/she must pay a bond premium, which means they would pay more than the face value for the bond.
With callable bonds, investors can receive higher interest payments without paying a bond premium. After all, these bonds do not always get called and many of them pay interest for the full term.
Should You Add Callable Bonds to Your Portfolio?
Similar with many other financial instruments, callable bonds are good additions to a diversified portfolio.
However, always keep in mind the qualities of these bonds and set your expectations right. There is no such thing as ‘free lunch’, and the higher interest payments received for a callable bond come with the risk diminished price appreciation as well as reinvestment risks.
On the other hand, these risks are linked to the falls in interest rates, making callable bonds a good tool for investors to strategize on the financial markets.
