The debt securities issued in the market can have many features; one such feature is an embedded option such as a call option. The call option gives the issuer the right to but the bond back from the investor at prespecified terms after a certain period. Similarly, there could be a put feature in the bond which will give the bondholder the right to return the bond to the issuer.
Such embedded options can influence the price of the bond depending on in whose favour the embedded option works. As we can see, the call option in a callable bond is a clear benefit to the issuer as it can call the bond back under unfavourable circumstances and issue a new bond. Therefore, the price that an investor would be willing to pay for this bond will be lower than an option-free bond.
The general equation is as follows:
Price of Callable Bond = Price of Option-free Bond – Price of Call Option
Due to the lower price, the callable bonds are also less sensitive to interest rate changes.
For puttable Bonds, the pricing is opposite, i.e., the price of the put option is added to the price of option-free bond, since it’s an additional benefit for the investor allowing him to sell the bond back to the issuer.
Here are some more interesting points about callable bonds:
- The issuer compensates the investor for the call option in the form of higher coupon.
- Government-sponsored entities are the largest issuers of callable bonds.
- Callable bonds provide natural hedge to the issuers; if the interest rates fall, they can call their bonds back and reissue at lower rates.
- Since callable bonds have lower price than option-free bonds, they also provide higher yield.
- Unlike a warrant, the call option is not detachable from the bond.
- The value of the call option converges to zero at maturity. It’s wiser to exercise as early as possible after the call protection period.
- Once the rates decline, the call should be exercised immediately before the rates rise again and the refinancing opportunity extinguishes.