A callable bond is a type of bond that allows the issuer to redeem or redeem it before its maturity date.
When we invest in debentures or bonds we can hold them to maturity or sell them to another investor in the secondary market. But these financial products are amortized on their maturity date.
However, in this case we are facing one that has a peculiarity and that is that the issuer reserves the right to recover it before the agreed date. In this way, interest payments are avoided when the market situation is not favourable.
How a redeemable bond works
Its operation is relatively simple. The issuer offers them on the market as it would traditional bonds. If the investor is interested in them, he buys them knowing that the issuer reserves the right to redeem them before maturity.
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To avoid the damage that early repayment entails for those who buy it, a higher yield is offered. In this way, a financial compensation is established that offers an incentive over the traditional ones, which are amortized on the scheduled date.
There are three ways to redeem a callable bond.
- Sinking fund swap: This is done according to a schedule previously established between the parties.
- Optional exchange: In this case, the issuer reserves the option to exchange it or not at maturity.
- Extraordinary exchange: When certain causes occur, provided for in the agreement, that allow the issuer to cancel it before expiration.
Advantages and disadvantages of the redeemable bonus
Here are two pros and cons.
- An advantage for the issuer is the possibility of redeeming it before maturity, if the market turns unfavourable. This has a drawback, that it must offer a higher interest rate to the investor.
- Another advantage is that, on many occasions, it is cheaper than a bank loan, that is, it has a lower financial cost. However, the drawback is that the company will have fewer financing options if it does not have recognized prestige.
Types of redeemable bonus
We have two types of redeemable bonus.
- On the one hand, those issued by public administrations, which will work the same as these in relation to interest, amortization or general conditions.
- Those issued by the private company. In this case the same thing happens, they are similar to the traditional ones in terms of their conditions.
Redeemable bond example
To finish, let’s see this simple example, in order to understand what has been exposed so far. We have a 10-year, 100-million-dollar bond with an annual interest rate of 5% and an amortization premium of 102%.
The company pays $5 million in interest each year (100*5%). Then these go down the following year to 3% and the company amortizes the bonds, returning 102 million dollars (100*102%). In turn, it borrows that money from the bank at that 3% market interest rate.
As we can see, the use of a callable bond allows you to pay 3% interest on that 102 million dollars of the loan, that is, 3.06 million dollars. We can verify that this amount is much less than what he paid before 5 million.