How a Callable Bond Works

A callable bond is can be redeemed early by the issuer of the bond (that is, before the maturity date). Date of purchase or redemption option is specified beforehand in the bonds (eg, five years after the date of issuance of bonds, etc.) with a pre-determined initial redemption price.

With these types of bonds, the issuer has the right (option) but not the obligation to buy back bonds from the bondholders with a predetermined price.

Redemption or repurchase price is usually set above the par value or the initial offering price of the bonds, issuer has the option of paying a coupon interest rate which is higher. If at the time of the option exercise date market interest rates go down then the bond issuer has the opportunity to reschedule its debt. And when the interest rate is lower then the issuer may execute its right to early redemption (call).

In the event that interest rates fall then bond prices will rise, so it is very profitable for the issuer to exercise the options in order to pay off early at par value.

Investors also own a profit by buying the bonds of this type because they can get a coupon interest rate that is higher than ordinary bonds. But on the other side of the market, if interest rates go down then the bond issuer will exercise the options after that investment, and the yields are low. This is supposing that a seller receives the option premium upfront, and when its time, the option can be exercised by the option buyer.

The largest number of the purchase option bonds in the market are bonds issued by institutions guaranteed by the government. Such as those issued by the U.S. Agencies, where they have a large number of mortgage and asset-backed securities.

In accordance with the re-issue, bonds with lower interest rates than the bond coupon rate continue to pay interest and can be redeemed.

Terms of callable bonds usually come into effect only after a few years. At the beginning, the redemption price may be higher than face value of bonds over time, but will gradually converge with the bond face value. However, it is capable of starting with the same face value.

Bond issuers will sometimes only redeem parts of the outstanding bonds. In this case, there are two ways to decide which bonds will be redeemed. First, the computer randomly selects a number of bonds, and second, the face value of all the bonds were redeemed by a certain percentage.