 Personal Finance PowerPoint Presentation, Callable Bond, prepare to get financially fit by practicing personal finance. Most of this information comes from Investopedia, Callable Bond, which you can find online. Take a look at the references, resources, continue your research from there. This by James Chin, updated April 2nd, 2022. In prior presentations, we've been taking a look at investment goals, investment strategies, investment tools, keeping them in mind. We're now asking, what is a callable bond? A callable bond, also known as a redeemable bond, is a bond that the issuer may redeem before it reaches the stated maturity date. So quick recap on the bonds in general, when we're thinking about investing from the investment perspective, we're often trying to diversify our portfolio, possibly having a portion of our investments in stocks or equities, and some in the bonds on the bonds side of things, oftentimes we think about it as fixed income types of investments, and we usually first think about the government bonds because that's a great measuring tool to measure other bonds against due to their being very low default risk because the government can, in essence, tax and basically print money if we're talking about the United States government, so they shouldn't default on the bonds. You would think bonds basically being kind of like a loan, so we're gonna be loaning money if we were to loan it or buy the bond from the government, then we would be giving the government money, they would be promising to pay us back the money at the maturity date, typically, and then typically have interest, which is similar to rent. In other words, if we were to rent, say, an apartment building, we would expect the apartment back at the end plus rental payments for the use of it. In this case, we would have the initial loan, in essence, or the amount that we purchased the bond for and that we would want, in essence, back, basically, and then the interest is gonna be the income that we would have. Keeping that in mind, we're now getting a little bit more complex on the bonds, looking at the callable bonds, noting that we're now talking about corporate bonds that oftentimes we're having these callable type of bonds. Okay, a callable bond, also known as a redeemable bond, is a bond that the issuer may redeem before it reaches the stated maturity date. That's the end term of the bond where you would usually receive the face amount. So a callable bond allows the issuing company to pay off their debt early. A business may choose to call their bond if market interest rates move lower, which will allow them to re-borrow at a more beneficial rate. So when you're looking at the corporation side of things, they might want the ability to call back the bonds at some point in time before the maturity date. If given the market rates, they have a more favorable condition to possibly re-up in essence, they're financing at the lower rates. So callable bonds thus compensate investors for that potential potentiality as they typically offer a more attractive interest rate or a coupon rate due to their callable nature. So if you're on the investment side of things with the callable bond, that's a feature that isn't on us on the investment side of things, meaning we don't have the capacity to do something like trade the bond in for stocks or anything like that, but rather it's a benefit to the other side of the equation who were basically loaning the money too. That's gonna be the corporation and the corporation has the benefit of being able to pay it off early so they could take advantage of the lower rates and therefore that means we're taking on kind of more risk on the investment side of things. So you would expect all else equal that we would want a greater return of the callable bonds than a similar bond that didn't have that callable feature. So how a callable bond works, a callable bond is a debt instrument in which the issuer reserves the right to return the investor's principal and stop interest payments before the bond's maturity date. Corporations may issue bonds to fund expansion or to pay off other loans. So if they expect market interest rates to fall, so they're gonna issue the bond. Remember what happens when you issue the bond. There's gonna be a maturity date typically. There's gonna be a rate on the bond. They're gonna be paying in accordance with that rate on the bond. Now market rates then if they fluctuate could be favorable or less favorable to us as the investor and to the person that we loaned in essence the money to, the corporation that issued the bonds. From our perspective, as the investor, if we have the interest rate risk, meaning if inflation goes up and we had a fixed rate of return on the bonds, that could be bad for us because now we could, if we had that money, invest in other similar investments at higher rates. If we had that money, if the interest rate goes down on the market, that would be good cause we locked in the higher rate on the corporate side of things. It's similar to as you might think of like your mortgage. If they locked in the rate and they have a liability and they're gonna be paying that rate to you, if interest rates go up, then they're good. That's good for them. Just like if you have a mortgage and basically the interest rates go up and you locked in the mortgage, you're the one that owes the money back. That's good because you're paying it back at the lower rates. However, if the rates go down, then that's gonna be bad. In a mortgage situation, if you would want to refinance with a corporate situation, they might wanna be able to have this callable component so they can basically, in essence, refinance. So if they expect market interest rates to fall, they may issue the bond as callable, allowing them to make an early redemption and secure other financings at a lower rate. The bonds offering will specify the terms of when the company may recall the note. A callable redeemable bond is typically called at a value that is slightly above the par value of the debt. The earlier in the bond's lifespan that it is called, the higher its call value will be. For example, a bond maturing in 2030 can be called in 2020. It may show a callable price of 102. This price means that the investor receives $1,020 when you see this 102 kind of way they're writing it. It's basically 102% 1.02 in a calculator if you were gonna calculate that out. So you take the $1,000 bond times 1.02 or 102% face value of their investment. So the bond may also stipulate that the early call price goes down to 101 after a year. So types of callable bonds. Callable bonds come with many variations. Optional redemption lets an issuer redeem its bonds according to the terms when the bond was issued. However, not all bonds are callable. So oftentimes you gotta think about whether you have this callable option or not. Treasury bonds and treasury notes are non-callable although there are a few exceptions. Most municipal bonds and some corporate bonds are callable and municipal bond has call features that may be exercised after a set period such as 10 years. Sinking fund redemption requires the issuer to adhere to a set schedule while redeeming a portion or all of its debts. On specified dates, the company will remit a portion of the bond to bondholders. A sinking fund helps the company save money over time and avoid a large lump sum payment at maturity. A sinking fund has bonds issued whereby some of them are callable for the company to pay off its debts early. So extraordinary redemption lets the issuer call its bonds before maturity if specific events occur such as if the underlying funded project is damaged or destroyed. Call protection refers to the period when the bond cannot be called. This issuer must clarify whether a bond is callable and the exact terms of the call option including when the timeframe, when the bond can be called. Callable bonds and interest rates if market interest rates decline after a corporation floats a bond the company can issue new debt receiving a lower interest rate than the original callable bond. The company uses the proceeds from the second lower rate issue to pay off the earlier callable bonds by exercising the call feature. So again, they're kind of trying to refinance their bonds because the interest rates go down in a similar fashion as you might think on the individual side trying to refinance your fixed mortgage as interest rates go down. So as a result, the company has refinanced its debt by paying off the higher yield callable bonds with the newly issued debt at a lower interest rate. Paying down debt early by exercising callable bonds saves a company interest expense and prevents the company from being put in financial difficulties in the long term if economic or financial conditions worsen. However, the investor might not make out as well as the company when the bond is called. For example, let's say 6% coupon bond is issued and is due to mature in five years and investor purchases $10,000 worth and receives coupon payments of 6% times 10,000 or 600 annually. Three years after issuance, the interest rate falls to 4% and the issuer calls the bonds. So now you bought them at the higher rate, the rates have fallen. So now the corporation is saying I would like to refinance in essence my debt if I have the capacity to do that, if I structured the bonds in a callable kind of fashion. The bondholder must turn in the bonds to get back the principal and further interest is paid. So in this scenario, not only does the bondholder lose the remaining interest payments, but it would be unlikely they will be able to match the original 6% coupon. So in other words, if they make their call option, then you're gonna get back basically the principal, which is great, that's fine. But now the whole reason that they called the bonds back is because there's a higher, because there's a lower market rate. So if you get the money back, you're not gonna be able to find an investment generally that is gonna give you the same level of risk at the rate of return you were getting before. And which is of course the reason that the corporation called back the debt. So this situation is known as reinvestment risk. So the investor might choose to reinvest at a lower interest rate and lose potential income. Also, if the investor wants to purchase another bond, the new bonds price could be higher than the price of the original callable. In other words, the investor might pay a higher price for a lower yield. As a result, a callable bond may not be appropriate for investors seeking stable income and predictable returns. So oftentimes from an individual investor standpoint, we're often thinking about almost a pure kind of investments meaning stocks are the stocks, right? And versus bonds being bonds. Once you put into these different kind of components or types of bonds, it can kind of confuse things. And oftentimes this giving you more risk on the investor side could result in you thinking that you might get more returns on it to some degree. But that callable feature is gonna add a level of risk and complexity. And therefore, when you're using the bonds to kind of balance out, for example, your portfolio, you might just be wanting to get bonds that don't have the callable feature oftentimes. But in any case, advantages and disadvantages of callable bonds. Callable bonds typically pay a higher coupon or interest rate to investors than non-callable bonds. The companies that issue these products benefit as well. Should the market interest rate fall lower than the rate being paid to the bondholders, the business may call the note. They may then refinance the debt at a lower interest rate. This flexibility is usually more favorable to the business than using bank-based lending. However, not on every aspect of a callable bond is favorable and issuer will usually call the bond when interest rates fall. This calling leaves the investor exposed to replacing the investment at a rate that will not return the same level of income. That's the point. That's why they want the call option because of the change in the rates. Conversely, when the market rates rise, the investor can fall behind when their funds are tied up in a product that pays a lower rate. So obviously, if the interest rate goes up, then you have the normal interest rate risk that you always have in the fixed bonds being that now you've locked yourself in to kind of the interest rate on the bond. But now, if you had the money, the interest rates might be higher and you might be able to get a bigger return if you were able to invest at that time. So finally, companies must offer a higher coupon to attract investors. So that's the benefit for the investor side of things. It's benefiting the company. Therefore, to do that, to have that call option, the corporation will typically have to have a higher return than other related or similar bonds. This higher coupon will increase the overall cost of taking on new projects or expansion. So what are the pros? Pay a higher coupon or interest rate on the investor that's a pro for the investor. Investor finance debt is more flexibility for the issuer, helps companies raise capital, call features allow a recall and refinancing of debt for the company side. Cons, investors must replace called bonds with lower rate products typically once they call them. Investors cannot take advantage when market rates rise. Coupon rates are higher raising the cost to the company. Example of a callable bond. Let's pay Apple Incorporate, AAPL decides to borrow $10 billion in the bond market and issues 6% coupon bond with a maturity date in five years. The company pays its bond holder 6% times 10 million or $600,000 in interest payments annually. Three years from the date of issuance, interest rates fall by 200 basis points to 4% prompting the company to redeem the bonds. So now they got this call feature, the market has gone down, they wanna refinance the bonds in essence. Under the terms of the bond contract, if the company calls the bonds, it must pay the investor's $102 premium per two par. Therefore, the company pays the bond investor's $10.2 million, which is borrowed from the bank at a 4% interest rate. It reissues the bond with a 4% coupon rate and a principal sum of 10.2 million, reducing its annual interest payments to 4% times 10.2 million or 408 million. So they're basically kind of refinancing their debt because in essence the interest rates went down.