Understanding Callable Bonds

Callable bonds are bonds that can be redeemed by the issuer at a pre-determined schedule at a pre-determined price. It is an option available to the issuer. The price at which bonds can be redeemed by the issuer is the call price. The time frame at which bonds can be redeemed before the maturity of bonds is termed as the call date. There is an assumption made by some investors that fixed income instruments guarantee interest income at regular intervals (generally semi-annually), as long as the default risks are low. However, that may not hold good all the time, as bonds may be called by the issuer before maturity and the proceeds may have to be reinvested by the investors. A similarly attractive bond may not be available as an investment opportunity.

When the markets are bullish or when the interest rates are getting lower, investors need to keep in mind the call risk associated with bonds. Bullish markets increase the demand for bonds and result in their prices moving up and yields coming down. In such a scenario, it would make sense for the issuing company to redeem the higher cost bonds and issue new bonds at lower cost/coupon.

Investors should consider Yield to Call of bonds, by assessing the probability of call. If the difference between the coupon on the existing bonds and the current interest rates is high, the probability of bonds being called is higher, as the company can save interest costs. Then the bonds should be valued at Yield to Call and not Yield to Maturity. Generally investors consider Yield to Worst on bond; however, when the time to call is low and the probability of call looks higher, Yield to Call becomes relevant.

The feature of callability is beneficial to issuing companies as it gives them the option to reduce their borrowing costs, when interest rates decline. Especially, when a company issues longer dated bonds, it is likely to be exposed to multiple interest rate cycles during that long period. Hence, it would not make sense for the company to lock in a high coupon rate for the entire period to maturity.

Let us look at an example; a Chinese property company Kaisa had issued 5 year USD bonds in 2010 at a coupon of 13.5%. It was callable on or after 28 Apr 2013 at a call price of 106.75. In the credit market rally of 2013, the yields on Asian high yield (HY) papers came down significantly. Kaisa issued USD 550 million 5 year junk bonds in Mar 2013 at 8.875%. This coupon is significantly lower compared to the coupon of 13.5% on its existing bonds. Hence, Kaisa called its 2015 bonds, using the proceeds of the newly issued USD notes.

Most of the high yield China property bonds issued in 2013 were callable bonds. Generally, 5 year bonds that can be called after 3 years and 7 year bond callable after 5 years were issued by these companies.

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