Understanding Redeemable Bonds

Jan 30, 2010
Unnikrishnan k

Difference Between Callable Bonds and Normal Bonds

A simple bond is usually a extremely easily understandable tool for investing. A simple bond will have a fixed maturity date, and pays out interest until the the bond is mature. The normal bond is easy and a secure investment. Different from the safe simple bond investment the callable bond or redeemable bond is an exercise in risk taking. Callable bonds are not simple by any means and instead of a set term of investment ending at a designated date these bonds have two possible expiration dates. In one case they can expire at the maturity date just as a normal bond, and in the other they can expire if the issuer exercises their call option.

How Callable Bonds Work?

To compensate for the risk, callable bonds will usually have a higher interest return on investment. If the issuer of the bond exercises the option to call the bond, then in most cases, the sooner it is called the higher the rate of interest paid can expected to be. If the interest rates in the market fall lower than the rate than the interest rate payout on the bond is, the issuer may decide to exercise their option to call the bond. The issuer will payout the rate of interest agreed upon when the bond was issued and in some circumstances may this may include a higher interest rate applied to the value in addition to this. Calling the bond in early helps to reduce any loss that would be incurred by current market interest rates being lower than the bond value if held to its maturity date.

To break this down a little think about a 20 year callable bond that bears a coupon rate of 8% and is callable after 4 years. Now if 4 years after issue the interest rates have gone down on 20 year callable bonds and are six percent for a new 20 year bond. It would be in the company’s best interest to exercise their call option on the the bond because they would pay a lower interest rate with a new bond and payout less over the long run. On the other hand if market interest rates were to raise to 11% the issuer would simply allow the bond to mature as it is not advantageous to call it.

Risks Associated With Callable Bonds

Callable bonds are risky and require experience, so most investors to the market wisely avoid them. In order to prepare to invest in callable bonds a new investor should know what yield to maturity and yield to call means and be able to differentiate between them. The simple bond investment return is calculated on their yield to maturity rate, plain and simple and that is the the bond’s interest payments and return of the original investment. On the other hand the yield to call rate is calculated in a similar manner but also calculates the return on investment should the issuer exercise their call option. The chance that the issuer will exercise the call option on callable bonds is yet another gamble for the bond holder.

Reference:www.sec.gov, site viewed on 31 January,2010