What it is:
How it works (Example):
The bond indenture will stipulate when and how a bond can be called, and there are usually multiple call dates throughout the life of a callable bond. Many corporate and municipal securities have 10-year call provisions.
For example, let's consider an XYZ bond issued in 2000 and maturing in 2020. The indenture might stipulate that Company XYZ may call the bond in the second, fourth, and tenth year.
The call provision in the indenture sets forth the call price, which is what the issuer must pay to redeem the bond if it does so before maturity. In our example, the indenture might say, "The XYZ bond due June 1, 2020, is callable on June 1, 2004, at a price of 105% of par." The indenture typically provides a table of call dates and corresponding prices as well.
Note that the call price is normally higher than the face value of the bond, but it decreases the closer the bond is to maturity. For example, Company XYZ is offering 105% of face value if it calls the bond after four years, but it may only offer 102% if it calls the bond in ten years, when it is closer to its maturity date.
The difference between the face value and the call price is called the call premium. In our example, the call premium is 5% in 2004. In many cases, the call premium is equal to one year's interest if the bond is called in the first year.
Why it Matters:
A callable bond is worth less to an investor than a noncallable bond because the company issuing the bond has the power to redeem it and deprive the bondholder of the additional interest payments he'd be entitled to if the bond was held to maturity.
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From the company's perspective, having the ability to call the bonds adds value because the company is given the flexibility to adjust its financing costs downward if interest rates decline. But the company has to take the call price into account when determining whether or not it is worth it for them to refinance its debt.
Typically, bonds are called when interest rates fall so dramatically, the issuer can save money by floating new bonds at lower rates. If by the time of the call date interest rates have significantly dropped, the issuer is motivated to call the bonds because doing so will allow it to refinance its debt at a cheaper level. From another perspective, the issuer is incentivized to buy bonds back at par value, because as interest rates go down, the price of the bonds goes up.
If interest rates drop, the bond's issuer will be strongly motivated to save money by replaying it callable bonds and issuing new ones at lower coupon rates. In these circumstances, the investor that holds the bonds will see his interest payments stop and obtain his principal early. If the investor then reinvests this principal in bonds again, chances are that he will be forced to accept a lower coupon rate that is in line with the prevailing (and lower) interest rates (called "interest rate risk").