Understanding callable bonds

What if the issuer of the bond you’re enjoying today decides to repay you earlier than expected?

This callable bond often offers a higher yield than traditional bonds, making it attractive to income-seeking investors. However, this higher yield comes with an important trade-off: the issuer has the right to repay the bond before maturity. 

Understanding how and when this can happen is essential to evaluating the bond’s true return potential and determining whether it fits your investment objectives. 

What is a callable bond?

A callable bond is a bond that gives the issuer the right, but not the obligation, to buy back all outstanding bonds at a predetermined price on or after specified dates.

In simple terms, the issuer can choose to repay investors before the bond's scheduled maturity date. When this happens, investors receive the call price and stop receiving future coupon payments. 

Types of call options

Callable bonds may have either discrete or non-discrete call options.

1. Discrete call option

   With a discrete call option, the bond can only be called on specific dates

How it works: 

If the issuer does not announce a call before December 25, 2026, the next opportunity to call the bond is December 25, 2027 at a price of 100.

If the issuer does not exercise the option on December 25, 2027, the bond can no longer be called and will remain outstanding until maturity.

2. Non-Discrete Call Option 

With a non-discrete call option, the bond may be called at any time after a specified date. With a non-discrete call option, the bond may be called at any time after a specified date. 

How it works:

The issuer may call the bond at any time from December 25, 2026 to December 24, 2027 at a price of 101.

The issuer may call the bond at any time from December 25, 2027 until maturity at a price of 100. 

This structure gives the issuer greater flexibility in deciding when to redeem the bond.

Why do issuers include a call option?

Callable bonds allow issuers to potentially reduce borrowing costs in the future.

The most common reason an issuer exercises a call option is when interest rates decline. In such an environment, the market value of an existing bond may rise above the call price. Rather than continuing to pay a relatively high coupon rate, the issuer may choose to redeem the bond and refinance at lower interest rates. 

For example: 

• A bond may be trading at 110 in the market.
• The issuer has the right to call it at 101.
• By exercising the call option, the issuer can retire the higher-cost debt and potentially issue new bonds at lower rates. 

An issuer may also exercise a call option if it has excess cash and wishes to reduce future interest expenses. 

What is the call process?

Typically, issuers must notify bondholders before exercising a call option. In many cases, the issuer must provide notice approximately 20 to 30 business days before the specified call date.

For bonds with non-discrete call provisions, the issuer generally has greater flexibility when determining the exact redemption date, subject to the terms of the bond documentation.

Do bondholders have a choice? 

Generally, no.

Once a call is announced, bondholders are required to sell their bonds back to the issuer at the specified call price. Investors may choose to sell the bond in the secondary market before the call date.

However, the market price will typically move closer to the expected call price as the call date approaches.

Why should investors pay attention to call features?

The most important consideration is that the issuer controls the decision to call the bond, not the investor. This means that callable bonds are often redeemed at times most beneficial to the issuer, which may not necessarily be advantageous for bondholders.

One of the primary risks associated with callable bonds is reinvestment risk.

When interest rates fall, issuers are more likely to redeem their bonds. While investors receive their principal back, they may then need to reinvest the proceeds in a lower-interest-rate environment.

As a result, future income may be lower than originally expected.

For example, imagine an investor purchases a callable bond paying 6%. If interest rates later fall to 4%, the issuer may decide to call the bond. The investor receives the call proceeds but may only be able to reinvest at 4%, reducing future income. 

What should investors consider before buying a callable bond?

1. Higher yield comes with additional risk
   Callable bonds generally offer a higher yield than comparable non-callable bonds. This additional yield compensates investors for the possibility of early redemption. 
    
2. Evaluate different return scenarios
   Investors should assess potential returns under different outcomes:
    
   • Yield to Maturity (YTM): The return if the bond is never called and is held until maturity.
   • Yield to Call (YTC): The return if the bond is redeemed on a specific call date
     For bonds with multiple call dates or non-discrete call features, you may calculate a separate YTC for each potential call date. 
      
3. Focus on yield to worst (YTW)
   
   An especially important metric for callable bonds is Yield to Worst (YTW).
   YTW represents the lowest possible yield among:
    
   • Yield to Maturity (YTM); and
   • All potential Yield to Call (YTC) calculations. 
      

Investors should pay attention not only to the YTW itself but also to the period over which that yield is achieved. The key question is whether that return remains acceptable if the issuer exercises its call option at the earliest economically favorable opportunity.

Investor takeaway

Callable bonds can be attractive investments for those seeking higher income, especially when the additional yield adequately compensates for the risk of early redemption. However, investors should look beyond the headline yield and carefully evaluate the bond's call features.

A good rule of thumb is to focus on Yield to Worst (YTW) rather than solely on Yield to Maturity. By understanding how returns may change if the bond is called before maturity, investors can make more informed decisions and better assess whether the bond aligns with their income needs, risk tolerance, and investment objectives.

For more information on corporate bonds, you may reach out to your Wealth Specialist or log in to Metrobank Wealth Manager. 
 

DANA LOUISE GERONIMO is an Investment Counselor at Metrobank under the Institutional Investors Coverage Division. She built her expertise through her previous roles as an Investment Specialist and as a Financial Markets Sector Management Trainee within the bank. Dana holds a Master’s degree in Industrial Economics from the University of Asia and the Pacific. Outside of work, she enjoys exploring different fitness centers and reading.