There are bonds with an embedded call option that grants their issuers the right to call them back or redeem them at a premium price before their respective maturity dates. These are called callable bonds or redeemable bonds and they represent one of the different types of bonds categorized according to their embedded option.
Callable bonds are like a game of musical chairs in which the issuer can stop the music at any moment and call back their bonds. The issuer holds the power and the bondholders never know when their callable bonds will be redeemed. This article highlights and describes the advantages and disadvantages of investing in callable bonds.
Pros: Advantages of Callable Bonds
Specifically, when an issuer calls a bond, it pays the bondholder the call price, which is usually based on the face value, together with accrued interest to date. Callable bonds afford their issuers the advantage of having the option to raise funding for refinancing purposes at a lower interest rate when market conditions change.
Callable bonds appeal to certain investors. Purchasing and holding them can grant their holders higher passive income and better overall returns than puttable bonds and other non-callable bonds. These bonds also have lower liquidity and credit risks than traditional bonds. The following are the specific advantages:
• Higher Coupon Rate and Yields: Two of the main advantages of callable bonds for investors stem from the fact that they can provide higher potential returns due to their higher coupon rates and higher yields than non-callable bonds. This better return potential comes from the fact that their issuers need to compensate for the risk of being called and give investors an incentive for purchasing them.
• Better Liquidity or Lower Liquidity Risk: Bonds tend to be more liquid than more aggressive investment options like stocks and futures. Callable bonds are even more liquid or have lower liquidity risk than non-callable bonds. This liquidity comes from having the option for investors to sell these bonds in the secondary market or the fact that they can be redeemed by the issuers before their maturity dates.
• Protection Against Rising Interests: Another advantage of callable bonds is that they can provide their holders with some level of protection against rising interest rates or periods of high interest. Take note that some issuers can redeem these bonds if the rate rises, and this allows investors to reinvest the proceeds in other bonds with higher coupon rates or investment options with better potential returns.
• Can Be a Flexible Investment Option: These bonds are also considered a flexible investment option due to their higher coupon rates and yields. These bonds also have a call protection period which enables holders to keep them for a certain period while barring issuers from calling them back. This makes these bonds ideal for investors with shorter and even undefined or indefinite investment horizons.
Cons: Disadvantages of Callable Bonds
Investing in bonds is safer than stocks and provides better returns than money market instruments. But bonds still have risks and the level of each risk also varies according to the specific nature and characteristics of a particular bond. Callable bonds have call risk and this creates uncertainties for their bondholders.
These bonds are also not suitable for investors who want to have a longer investment horizon or who want to keep their investments intact for the long haul while receiving a passive stream of income from coupons or interests. Holding these bonds runs the risk of becoming too liquid. The following are the specific disadvantages:
• Potential For Losing Investments: Call risk is one of the main disadvantages of these bonds. Remember that issuers can redeem these bonds before their maturity dates. This creates problems in predicting the cash flows of a portfolio. It is also possible for an investor to lose his or her investments held in less liquid assets and end up becoming burdened with too much cash on hand.
• Risk of Lower Returns in the Future: There is a potential for holders of these bonds to have lower investment returns in the future when interest rates fall. Issuers can redeem their issued callable bonds during periods of lower interest and raise funding by issuing newer bonds with lower coupon rates benchmarked to the prevailing low-interest environment. This is another disadvantage of callable bonds.
• Heightened Reinvestment Risk: Remember that issuers are prone to redeeming their issued callable bonds from their bondholders during periods of low interest rates. This fact creates reinvestment risk. Holders of these bonds face reinvestment risk stemming from the possibility that they would not be able to reinvest the proceeds at the same rate of return or the same investment cost.
• Possible Lower Yield and Price Volatility: Callable bonds tend to have higher yields than non-callable bonds but these yields can also be lower than other bonds with similar credit ratings and maturity dates due to the possibility of early redemption. These bonds can also be subjected to volatile prices in the bond market. Price volatility stems from a changing interest rate environment.