Key Characteristics of Bonds

Par value is the amount of money a holder will get back once a bond matures; a bond can be sold at par, at a premium, or at a discount. The coupon rate is the amount of interest that the bondholder will receive per payment, expressed as a percentage of the par value. Maturity date refers to the final payment date of a loan or other financial instrument. A callable bond allows the issuer to redeem the bond before the maturity date; this is likely to happen when interest rates go down. A sinking fund is a method by which an organization sets aside money to retire debts. Other important features of bonds include the yield, market price, and putability of a bond.

Call Provisions

A callable bond allows the issuer to redeem the bond before the maturity date; this is likely to happen when interest rates go down.


LEARNING OBJECTIVE

  • Classify a bond based on its call provision

KEY POINTS

  • A callable bond is a type of bond that allows the issuer of the bond to retain the privilege of redeeming the bond at some point before the bond reaches its date of maturity.
  • If interest rates in the market have gone down by the time of the call date, the issuer will be able to refinance its debt at a cheaper level and so will be incentivized to call the bonds it originally issued.
  • Most callable bonds allow the issuer to repay the bond at par. With some bonds, the issuer has to pay a premium, known as the call premium.
  • Price of callable bond = Price of straight bond – Price of call option. Price of a callable bond is always lower than the price of a straight bond because the call option adds value to an issuer.

TERMS

  • straight bond

    A straight bond is a bond with no embedded options (call or put options). 

  • par

    Equal value; equality of nominal and actual value; the value expressed on the face or in the words of a certificate of value, as a bond or other commercial paper.

 

Occasionally a bond may contain an embedded option. That is, it grants option-like features to the holder or the issuer. A callable bond (also called redeemable bond) is a type of bond that allows the issuer of the bond to retain the privilege of redeeming the bond at some point before the bond reaches its date of maturity. In other words, on the call date, the issuer has the right, but not the obligation, to buy back the bonds from the bond holders at a defined call price. Technically speaking, the bonds are not really bought and held by the issuer. They are instead cancelled immediately.

Call dates are the dates on which callable bonds can be redeemed early.

There are three main categories.

  1. A Bermudan callable has several call dates, usually coinciding with coupon dates.
  2. A European callable has only one call date. This is a special case of a Bermudan callable.
  3. An American callable can be called at any time until the maturity date.


Redeemed Bonds: This Bond is one of the 400 issued to the Central Pacific Rail Road Company of California and 200 to the Western Pacific Rail Road Company in 1865 under the Act of the California Legislature passed on April 22, 1863. Coupon #1 was redeemed and cancelled on November 2, 1865, and coupon #35 on November 2, 1882, at which time the principal of $1,000.00 in gold coin was also paid from the Treasury of the City and County of San Francisco and the Bond was cancelled.

Most callable bonds allow the issuer to repay the bond at par. With some bonds, the issuer has to pay a premium, known as the call premium. This is mainly the case for high-yield bonds. These have very strict covenants, restricting the issuer in its operations. To be free from these covenants, the issuer can repay the bonds early, but only at a high cost.

The issuer has an option, for which it pays in the form of a higher coupon rate. If interest rates in the market have gone down by the time of the call date, the issuer will be able to refinance its debt at a cheaper level. The issuer will be incentivized to call the bonds it originally issued. Another way to look at this interplay is that as interest rates go down, the price of the bonds goes up. Therefore, it is advantageous to buy the bonds back at par value. With a callable bond, investors have the benefit of a higher coupon than they would have had with a straight, non-callable bond. On the other hand, if interest rates fall, the bonds will likely be called, and they can only invest at the lower rate.

The price behavior of a callable bond is the opposite of that of puttable bond. Since call option and put option are not mutually exclusive, a bond may have both options embedded.

Price of callable bond = Price of straight bond – Price of call option

Price of a callable bond is always lower than the price of a straight bond because the call option adds value to an issuer. Similarly, yield on a callable bond is higher than the yield on a straight bond.