Let’s break this apart. “Callable bond” is made up of two words – “callable” and “bond”.
A “bond” is just an IOU. It’s just an agreement between a company and investors whereby investors will receive a fixed interest payment (usually every year) for the lifetime of the bond. Once the bond has reached its maturity date, the original principal will be paid back to the investor.
This next part is slightly more confusing.
“Callable” refers to a clause in the contract that states that the company can buy back the bond from the investor. This clause is called a “call feature”.
A callable bond is typically seen as riskier because there is a chance that an investor’s profits can be reduced if the bond were to be called if market prices were to increase.
Let’s use an example:
- There is a company John’s Supplier
- They issue callable and non-callable bonds
- Face value (or original price) is $100
- Interest rate of callable bonds are 5%
- Interest rate of non-callable bonds are 3% (Interest rates are lower since non-callable bonds are safer)
In the event that the market price of the bonds increase to $150, John’s Supplier can buy back all callable bonds (by using the call feature).
Most importantly, John’s Supplier can buy back shares at $100 instead of the market price of $150. This means that John’s Supplier is saving $50 per bond!
Therefore callable bond investors lose out on their earnings of $50 per bond, therefore making callable bonds riskier. However, investors do get a higher interest rate to compensate for the risk (as seen in the 2% interest rate difference above).
How are callable shares usually used by companies?
Callable shares are used in one of two ways by companies:
- The company has a huge influx of cash and decides to pay off its debt
- The company has become more credit worthy, which allows it to borrow (or make another bond offering) at a lower interest rate
Let’s talk about the second option using our imaginary company John’s Supplier from above.
John’s Supplier has become more credit worthy due to growth in sales. Therefore, its interest rates (for regular non-callable bonds) have now fallen from 5% to 2%. It doesn’t make sense for John’s Supplier to pay 3% for callable bonds when it can pay 2% interest. Therefore:
- John’s Supplier does another bond offering at 2% interest per bond
- John’s Supplier uses the call feature to buyback all 3% interest callable bonds
- John’s Supplier now pays 2% instead of 3% interest on the same amount of money, and gets an extension of the loan (assuming that the lifetime of both bond offerings are the same)
