How it works (Example):
Callable bonds usually have a call schedule. This is a series of call dates on or before which the issuer can redeem the bond at specific prices. The call schedule can be found in the bond's prospectus.
Let's look at an example.
In return for including the call feature, Company XYZ's 5% interest rate on the bond is likely higher than what other issuers of similar risk and maturity offer on their noncallable bonds. But in return, Company XYZ has the built-in option to refinance its debt if interest rates fall.
Now let's assume that in late 2013, interest rates fall dramatically. On December 1, 2013, Company XYZ informs its bond investors that it will call the 5% bonds and issue new 3% bonds. The company pays investors a call premium of $50 per bond, and investors miss out on about two years of interest payments at 5%.
Why it Matters:
Embedded call options make bond analysis considerably more complicated because they introduce two additional dimensions of risk to bondholders. First, they increase reinvestment risk because when interest rates fall, the bond issuer is more likely to exercise the call option in order to refinance higher interest debt with lower interest debt. This leaves the investor with cash that must be reinvested at the prevailing lower market rate.
Second, call options put a ceiling on a bond's potential price appreciation because when interest rates fall the market assumes the bond will be called at its call price, and the price will not go any higher than its call price. Thus, the true yield of a callable bond (known as "yield to ") is almost always lower than its yield to maturity.
Because call provisions put investors at a disadvantage, bonds with call provisions tend to be worth less than noncallable bonds with the same terms. So in order to entice investors to buy, companies must offer higher coupon rates on callable bonds.