Callable Bonds: Why Demand Higher Yields From Investors?

Imagine you’re lending money to a company or government when you buy a bond. Think of it like giving a loan with the promise that you’ll get your money back plus interest over a set period. Now, what if the borrower had the option to pay back the loan early, even if you didn’t want them to? That’s essentially what a call provision in a bond is.

A call provision is like a special clause written into the bond agreement that gives the bond issuer, the borrower, the right to redeem the bond before its maturity date. It’s like having an ‘early repayment’ option on your loan, but from the borrower’s perspective. They can essentially ‘call back’ the bond.

Why would a company or government want this option? Well, interest rates in the market can change. Let’s say a company issues bonds when interest rates are relatively high. If rates later fall significantly, the company might find itself paying a higher interest rate on its existing bonds than it would if it issued new bonds at the current, lower rates. A call provision allows them to refinance, just like you might refinance your home mortgage to take advantage of lower interest rates. They can call back the old, higher-interest bonds and issue new bonds at the lower current interest rate, saving themselves money on interest payments over time.

But what does this mean for you, the bond investor? Think about it from your perspective. You bought a bond expecting to receive interest payments for a certain number of years and get your principal back at maturity. If the bond is called, this plan is disrupted. Suddenly, you receive your principal back sooner than you anticipated. While getting your money back might sound good, consider the situation where interest rates have fallen. The very reason the issuer is calling the bond is likely because rates are lower. This means when you get your money back, you’ll have to reinvest it in a market where interest rates are less attractive. You might not be able to find another investment with the same level of return and risk as the bond that was just called. This is often referred to as reinvestment risk. You could be forced to accept a lower interest rate on your reinvested funds.

Because of this reinvestment risk and the potential loss of higher future interest payments, investors view a call provision as a disadvantage. It introduces uncertainty and the possibility of lower returns. To compensate for this added risk, investors will demand a higher yield on a callable bond compared to an otherwise identical bond that doesn’t have a call provision.

Think of it like this: imagine two identical ice cream cones. One comes with a guarantee that you can enjoy it until the very last bite. The other comes with a chance that someone might take it away from you before you’re finished, say if they decide they want it back. Which ice cream cone would you value more, assuming all else is equal? You would likely value the guaranteed one more. To make the second ice cream cone just as appealing, the seller might have to offer you a little something extra, maybe a bigger scoop of ice cream or a better flavor, to compensate for the risk of it being taken away early.

Similarly, with bonds, the ‘something extra’ is a higher yield. Investors demand a higher rate of return on callable bonds to compensate for the risk that the bond will be called and they’ll have to reinvest their money at potentially lower rates. Therefore, generally speaking, a callable bond will trade at a slightly lower price than an otherwise identical non-callable bond, or, to put it another way, a callable bond must offer a higher yield to attract investors compared to a non-callable bond with all other features being the same. This higher yield reflects the added risk and reduced certainty that comes with the call provision.