Callable Bond: Definition

A callable bond, or redeemable bond, gives the bond issuer the right to purchase the bond back from the bond holder before the maturity date of the bond. Issuers will compensate the bond holder with an option premium to allow themselves the opportunity to purchase the bond back if they are paying the bond holder a higher coupon than the market bears.

Upon calling a bond, the issuer will then resell the bond back onto the open market with a lower coupon consistent with current market conditions.

Callable bonds can be unsettling for many investors as they think they have locked in a high interest rate for years ahead, only to have the bond repurchased by the issuer when market interest rates drop. Municipal and corporate bonds can be subject to a call while the treasury bonds are no longer issued with any call provisions, therefore, carefully check the bond prospectus of any "munis" or corporate bonds that you are looking to buy.

Types of Call Option Provisions

A callable bond will have a call option that will be one of three types: American, European, or Bermudan. These three different options will stipulate different conditions as to when the bond may be called up until.

Lockout Period

The lockout period is a period of time that must pass before the bond can be called. For example, if a bond is a 5nc2, this means the bond is a five year bond that is not callable for 2 years. In this case, 2 years is the lockout period. As you see from the descriptions below, Lockout periods apply with Bermudan and European call options.

Option Types

An American call option allows the bond issuer to repurchase the security at any time during the term of the bond and therefore cost the issuers the highest option premium.

Bermudan call options are a little less flexible than the American option in that they give the issuer the right to repurchase the bond on specific dates after the lockout period. These specific dates usually fall in line with coupon payments.

European call options are the least flexible type of call option providing a one time option to the issuer to repurchase the bond. This decision is usually made at the end of the lockout period. This type of callable bond has the least option premium.

See You at the Top,

This article is by Kunal Vakil who is the co-founder of mysmp.com (My Stock Market Power) which provides education on all topics finance; including stocks, bonds, options, futures, forex, technical analysis, and more! Please visit:www.mysmp.com

---------------------------------------------------------------------------