WHAT ARE CHARACTERISTICS OF CALLABLE BONDS?

When a company may redeem a bond after a certain date, this callability is sometimes termed a deferred call.  For instance, if you own a bond that may be called after five years, you own a bond with a deferred call provision. You may want to look for bonds that offer call protection—or some measure of time during which the bond may not be called. If you own a bond that may be called at any time, you own a freely callable bond.  In contrast, noncallable bonds cannot be called until maturity, and bonds with this feature offer the investor non-callability. When you are considering purchasing a bond, you may want to determine the yield-to-call, which is the calculation of the bond's rate of return if it is called as soon as possible—in other words, at the call date.  The yield-to-call takes into account the purchase price, redemption price, annual interest payments, and amount of time remaining to the call date.

For example, say that you purchased a $1,000 bond paying 10 percent interest, and that you paid a discounted price of $800 for the bond. It has a call date five years hence, when the company will pay you the bond's par value.  To calculate the yield-to-call:

Subtract your price from the par value ($1,000 - $800 = $200) Divide this figure by the number of years to callability ($200/5 = $40) Add the annual interest payments ($40 + $100 = $140) Add the price you paid to the par value, then divide by 2 ($800 + $1,000/2 = $900) Divide this figure into your answer for step 3 ($140/$900 = 15.5%)

Occasionally, a municipal bond might be redeemed through a catastrophe call, for example, following the destruction of a toll bridge that served as a revenue source to back the bond.  In this extraordinary case, investors likely would be paid from funds received from an insurance policy on the bridge.

Callable bonds are an important source of capital for some companies. We will discuss why in our next section.