Encyclopedia of Investment Terminology

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Callable Bonds and Redeemable Bonds

Callable Bonds and Redeemable Bonds are bonds that can be redeemed or paid off by the issuer prior to the bonds' maturity date. When an issuer calls its bonds, it pays investors the call price (usually the face value of the bonds) together with accrued interest to date and, at that point, stops making interest payments. Call provisions are often part of corporate and municipal bonds, but usually not bonds issued by the federal government.

An issuer may choose to redeem a callable bond when current interest rates drop below the interest rate on the bond. That way the issuer can save money by paying off the bond and issuing another bond at a lower interest rate. This is similar to refinancing the mortgage on your house so you can make lower monthly payments. Callable bonds are more risky for investors than non-callable bonds because an investor whose bond has been called is often faced with reinvesting the money at a lower, less attractive rate. As a result, callable bonds often have a higher annual return to compensate for the risk that the bonds might be called early.

There are three primary types of call features, including:

Optional Redemption. Allows the issuer, at its option, to redeem the bonds. Many municipal bonds, for example, have optional call features that issuers may exercise after a period of years, often ten years.

Sinking Fund Redemption. Requires the issuer to regularly set aside money for the redemption of the bonds before maturity.

Extraordinary Redemption. Allows the issuer to call its bonds before maturity if certain specified events occur, such as the project for which the bond was issued to finance has been damaged or destroyed. Before buying a bond, you should always ask your broker if there is a call provision and, if so, when and under what circumstances the bond can be called. You should also read any of the bond's offering documents that come from the issuer or contact your broker who sold you the bond.

You should be cautious in buying a callable bond at a premium (above the bond's face value), especially if the callable date is in the near future. If your bond is called, you may not get back what you paid. You will be paid the call price, which often is only the value on the face of the bond.

Much of the above information is courtesy of the SEC.

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