Callable Bonds and Early Redemption Features

This type of bond comes up when an issuer converts fixed-rate funding to a floating rate, and when an investor looks for a place to put money returned by a redemption.

Bonds the issuer can redeem before maturity

A callable bond is a bond that the issuer can redeem before maturity on dates and at a price set in advance. When the issuer chooses to redeem a bond before maturity, this is redemption before maturity. What a Japan Securities Dealers Association document calls the "early redemption clause" of Nikkei Stock Average-linked notes is different: the note is redeemed automatically if the Nikkei Stock Average is at or above a set level, and the issuer has no choice¹.

Consider a fictional example of a callable bond issued by Company E, on the following terms.

Company E decides whether to call the bond, and the investor has no say. In this example the call price is the face value. According to a 1998 manual for examiners by the US Federal Reserve Board (FRB), US corporate bonds are, as a rule, callable at a price above face value, and the amount above face value shrinks as the bond approaches maturity².

The table compares what the investor receives if Company E calls the bond on the coupon date after 2 years and if it does not.

Figure description

Payments seen by an investor who bought the callable bond of the fictional Company E (face value 1 million yen, term 5 years, coupon rate 2% a year), when Company E calls the bond on the coupon date after 2 years. The investor pays 1 million yen at issue, receives 20,000 yen of interest after 1 year, and after 2 years receives 1.02 million yen, made up of 20,000 yen of interest and the principal of 1 million yen. Because the bond has been called, nothing is paid or received from year 3 to maturity in year 5. The length of each arrow is a rough guide to the size of the amount. Once the bond is called, the investor no longer receives the 60,000 yen of interest that would have been paid after the call date.

Splitting the bond: the investor sells a call to the issuer

How to split a bond into a bond and an option is covered in What Are Structured Products? An investor who buys a callable bond is in the same position as one who buys a noncallable bond and, at the same time, sells the issuer the right to buy that bond back at face value²³. The right the issuer holds is a call option (call) with the noncallable bond as the underlying asset and the face value as the strike price⁴. Japanese structured notes also include a form in which the investor sells the issuer the right to redeem early on each semiannual coupon date and receives an option premium in return⁵.

This split gives the following relationship between values³.

$$P_{\text{callable}} = P_{\text{noncallable}} - C$$

$P_{\text{callable}}$ is the value of the callable bond, $P_{\text{noncallable}}$ is the value of a noncallable bond with the same coupon rate and maturity, and $C$ is the value of the call held by the issuer. In Company E's example, discounting a noncallable 5-year, 2% bond at 1.5% a year (the yield on Company E's noncallable bond) gives a value of about 1.024 million yen⁶. If the callable bond is sold at its face value of 1 million yen, the call is worth about 24,000 yen. The extra 0.5% of face value that the investor receives in interest each year is the payment for this call².

Company E's right can be exercised only on set dates after 2, 3 and 4 years, so its exercise style is that of a Bermudan option⁷.

How calls and prices change when rates move

When rates fall, the issuer becomes more likely to call the bond. If market rates are below the bond's coupon rate on a call date, the issuer redeems the bond and can refinance at a lower rate²⁹. The risk that an investor whose bond is called has to reinvest the proceeds at lower rates is called reinvestment risk¹⁰.

In Company E's example, suppose that after 2 years, the yield on a 3-year bond with the same credit as Company E has either fallen to 1% a year or risen to 3% a year. In the first case, Company E calls the bond after 2 years, and the investor uses the returned 1 million yen to buy a 3-year bond paying 1% a year.

If the yield falls, the investor's interest is 40,000 yen for the first 2 years plus 30,000 yen (10,000 yen a year) for the 3 years after reinvesting, 70,000 yen in total. A noncallable bond at 1.5% a year would pay 75,000 yen over 5 years, so the investor receives 5,000 yen less. If the yield rises, Company E cannot refinance at a lower rate by calling the bond, so it does not call. The investor receives 100,000 yen over 5 years, 25,000 yen more than on the 1.5% bond. In that case, however, the investor keeps holding a 2% bond while the market yield is 3% a year, and selling it before maturity brings a price below face value⁷.

The price also moves differently from that of a noncallable bond. As rates fall and a call becomes more likely, the call held by the issuer gains value, and the price of the callable bond rises more slowly¹¹.

How much rates move (volatility) also affects the result of a callable bond. Because the investor has sold a call, when rates swing widely, the investment result of a callable bond falls short of that of a similar noncallable bond¹². When rates fall, the bond is more likely to be called, so the investor gains little from the price rise, and when rates rise, the bond loses value just as a noncallable bond does¹¹.

Step-up callable bonds

A step-up callable bond is a callable bond whose coupon rate rises in steps at set times if the bond is not called. According to the FRB manual of 1999, step-up bonds are generally callable by the issuer, and their initial yield is set higher than that of a noncallable fixed-rate bond with the same maturity. A bond whose coupon rate rises at two or more times is called a multi-step⁷.

Consider a step-up callable bond from Company E. As in the earlier example, it has a face value of 1 million yen and a term of 5 years, and Company E can redeem it at face value on the coupon dates after 2, 3 and 4 years.

If the coupon rate on Company E's noncallable bond stays at 1.5% a year, the coupon rate from year 3 on is well above the rate at which Company E could refinance. Company E is therefore likely to call the bond after 2 years, and the investor is likely to receive only 36,000 yen for those 2 years. A coupon rate that keeps rising makes the call held by the issuer more valuable and also makes a call more likely⁷. On the other hand, if rates rise and Company E does not call, the investor receives 120,000 yen over 5 years. If market rates are above the coupon rate, however, selling the bond before maturity brings a price below face value⁷.

How the issuer hedges with a swap

For an issuer that uses an interest rate swap to turn the fixed rate on funds raised with a callable bond into a floating rate, the problem is that calling the bond leaves the swap in place. Suppose Company E issues 10 billion yen of callable bonds at 2% a year and enters into a swap with a dealer, receiving a fixed rate of 2% a year and paying a floating rate. If the swap keeps its 5-year term, the swap payments continue for the remaining 3 years even after Company E calls the bond after 2 years.

Institutions with obligations whose principal can be repaid early, such as callable bonds, typically use swaps with a termination right (cancelable swaps) to avoid a mismatch between the terms of the obligation and of the swap that hedges it¹⁵. In Company E's example, if Company E has the right to terminate the swap after 2, 3 and 4 years, it can end the swap on the day it calls the bond. The FRB manual of 1998 calls a swap in which the fixed-rate payer holds the termination right a callable swap, and one in which the fixed-rate receiver holds it a putable swap¹⁵. In this example, Company E receives the fixed rate and holds the right, so in the manual's terms the swap is a putable swap.

An issuer that borrows at a fixed rate without a swap can also collect the value of its call right in advance as a premium. It does this by selling a dealer the right to start, on a call date, a swap in which the dealer receives the fixed rate and pays the floating rate (a swaption). In exchange, it gives up the gain it would have made by borrowing again at a lower rate if rates fell⁹.

Risk that the redemption date is not fixed

The investor in a callable bond chooses neither whether nor when the bond is called. A call becomes likely when market rates have fallen¹⁰. The period over which the investor receives interest is not fixed at issue, and it tends to be shorter the further rates fall. The issuer's credit risk and the difficulty of selling before maturity are risks common to structured products.

Differences by who holds the right and what triggers redemption

Bonds redeemed before maturity differ by who holds the right and what decides the redemption.

A put bond is the reverse of a callable bond: the investor has bought a put option (put) from the issuer. In return for the put, the issuer pays a lower coupon rate. If market rates are above the bond's coupon rate on a put date, the investor can sell the bond back to the issuer and reinvest the proceeds at higher rates¹⁶. Its value is the value of a noncallable bond plus the value of the put¹⁷.

On a bond with an autocall feature, the issuer does not choose whether to redeem. The bond is redeemed automatically if the stock price or other value on an observation date is at or above a set level¹. An example of automatic early redemption on a structured note linked to a stock is covered in Exchangeable Bonds (EB).

Notes

1. Japan Securities Dealers Association, "日経平均リンク債の特徴やリスクとは？" (What are the features and risks of Nikkei Stock Average-linked notes?, in Japanese), page 1, "１．そもそも日経平均リンク債とは？" (1. What is a Nikkei Stock Average-linked note?). The source's terms are "早期償還判定水準" (early redemption trigger level) and "早期償還条項" (early redemption clause). ↩ ↩²

2. Board of Governors of the Federal Reserve System, "Trading and Capital-Markets Activities Manual" (February 1998), Section 4045.1 "Corporate Notes and Bonds," page 3, "Callable Bonds." ↩ ↩² ↩³ ↩⁴

3. Jennifer Carpenter, "American Options, Callable Bonds, and Swaptions" (lecture notes, New York University Stern School of Business), "Valuing the Callable Bond" (page 12 of the PDF). The passages with the value formula and the positions of the issuer and the investor. ↩ ↩²

4. The same source, "American Call on the 1.5-Year 5.5%-Coupon Bond" (page 8 of the PDF). ↩

5. Center for Advanced Financial Technology, Financial System and Bank Examination Department, Bank of Japan, "仕組商品投資のリスク把握と管理" (Understanding and managing the risks of investing in structured products, in Japanese), the worked example in "２．商品の仕組みとリスク特性" (2. Product structure and risk characteristics), pages 4–7. The right is called "期限前解約権" (early termination right). ↩

6. The sum of the annual interest of 20,000 yen and the principal of 1 million yen after 5 years, each discounted at 1.5% a year with annual compounding (about 1,023,900 yen). The text uses a rounded value. ↩

7. Board of Governors of the Federal Reserve System, "Trading and Capital-Markets Activities Manual" (March 1999), Section 4040.1 "Structured Notes," pages 1–2, "Step-Ups/Multi-Steps." ↩ ↩² ↩³ ↩⁴ ↩⁵

8. Jennifer Carpenter, "American Options, Callable Bonds, and Swaptions" (lecture notes, New York University Stern School of Business), pages 11–13 of the PDF, from "Class Problem: American Call" to "Class Problem: Callable Bond." ↩

9. Board of Governors of the Federal Reserve System, "Trading and Capital-Markets Activities Manual" (February 1998), Section 4340.1 "Swaptions," page 2, "Enhancing Embedded Call Option Value in Fixed-Rate Callable Debt." ↩ ↩²

10. Board of Governors of the Federal Reserve System, "Trading and Capital-Markets Activities Manual" (September 2001), Section 4045.1 "Corporate Notes and Bonds," page 5, "Prepayment or Reinvestment Risk." ↩ ↩²

11. Jennifer Carpenter, "American Options, Callable Bonds, and Swaptions" (lecture notes, New York University Stern School of Business), "Negative Convexity of Callable Bonds" (page 18 of the PDF). ↩ ↩² ↩³

12. Board of Governors of the Federal Reserve System, "Trading and Capital-Markets Activities Manual" (February 1998), Section 4040.1 "Structured Notes," page 8, "Market Risk." It covers structured notes in general in which the investor has sold options. ↩

13. Jennifer Carpenter, "American Options, Callable Bonds, and Swaptions" (lecture notes, New York University Stern School of Business), "The Market for Swaptions" (page 19 of the PDF). ↩

14. The same source, "Option-Adjusted Spread" and "OAS" (pages 16–17 of the PDF). ↩

15. Board of Governors of the Federal Reserve System, "Trading and Capital-Markets Activities Manual" (February 1998), Section 4340.1 "Swaptions," page 1, "Cancelable Swaps." ↩ ↩²

16. Board of Governors of the Federal Reserve System, "Trading and Capital-Markets Activities Manual" (February 1998), Section 4045.1 "Corporate Notes and Bonds," page 3, "Put Bonds." ↩

17. Jennifer Carpenter, "American Options, Callable Bonds, and Swaptions" (lecture notes, New York University Stern School of Business), "Swaptions and Cancelable Swaps" (page 27 of the PDF). ↩