What Is A Callable Bond And How Do They Work?

What Is a Callable Bond?

A callable bond, also referred to as a redeemable bond, is a bond that the issuer may redeem before it reaches the stated maturity date therefore, allowing the issuing company to pay off their debt early, should they choose to. An issuer may want to call their previously issued callable bonds if market interest rates lower, the issuer will return the original investment amount to the bondholder, and no further interest payments are made.  Lower interest rates allow the issuer to re-borrow at a lower, more beneficial rate.  However, a callable bond will usually have a certain amount of call protection, preventing the issuer from calling the bond during the first few years of the bond.

For example, say a company issues a 30 year bond with an 8% coupon rate.   Each year, the issuer makes interest payments to the bondholder, but after 10 years, interest rates have fallen substantially lower and the issuer is now able to borrow the same amount of the outstanding loan at a much lower interest rate, therefore, prompting them to redeem the 30 year bond after only 10 years. Due to the possibility of a bond being redeemed prior to maturity, callable bonds compensate investors for that potentiality as they typically offer a more attractive interest rate or coupon rate due to their callable nature.