Callable Bond
A callable bond also known redeemable bond is a type of debt security bond that permits the issuer of the bond to hold back the privilege of redeeming the bond at some break point before the bond achieves its date of maturity. In other sense, on the call date, the issuer has the right, but not the responsibility, to buy back the bonds from the bond holders at a specified call price. Technically addressing, the bonds are not actually bought and held by the issuer but are rather canceled immediately.
The call price will generally exceed the issue price. In some cases, specially in the high-yield debt market, there can be a significant call premium.
Therefore, the issuer has an choice for which it gives in the form of a higher coupon rate. If interest rates in the market have moved down by the time of the call date, the issuer will be capable to refinance its debt at a cheaper level and so will be in certain to call the bonds it in the beginning issued. Another option to look at this interaction is that as interest rates move down, the price of the bonds move up. Thus, it is favorable to buy the bonds back at par value.
With a callable bond, investors have the profit of a higher coupon than they would have had with a direct non-callable bond. On the other hand, if interest rates moves down, the bonds will be expected to called, and they can only invest at the lower rate. This is corresponding to dealing an option, the option writer acquires a premium up front, but has a negative aspect of something that is generally positive if the option is practiced.
The biggest market for callable bonds is that of issues from government sponsored entities. They possess a lot of mortgage-backed securities and mortgages. In the U.S. Mortgages, contrary to other countries, there are generally fixed rate and can be prepaid early without cost. If rates move down, many of home owners will finance again at a lower rate. This means that the agencies fall behind assets. By issuance of a large number of callable bonds, they have a instinctive hedge, as they can then call their own issues and refinance at a lower rate.
The price conduct of a callable bond is the contrary to that of put table bond. For the reason that, put option and call option are not mutually exclusive, a bond may have both choices enclosed firmly.
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