WHY DO COMPANIES ISSUE CALLABLE BONDS?

The primary reason that companies issue callable bonds rather than non-callable bonds is to protect them in the event that interest rates drop.  For instance, if a company issues bonds that pay investors the going rate of 7 percent annually in interest, and then the going rate declines to 6 percent, the company may redeem its callable bonds, replacing them with new bonds paying 6 percent annually.

This is especially crucial for bonds with maturity dates 20 years or more into the future.  Without callability, a company might issue bonds with a high interest rate and not be able to change the rate for 20 years.  The company could find itself locked into a high rate for many years at a time when new bonds are being issued with much lower interest rates.  The company would be at a competitive disadvantage if it continued to finance its debts at the old, higher rate.

Companies are often willing to pay a premium to redeem the bonds before maturity, to avoid the above scenario.  Callability enables the company to respond to changing interest rates, refinance high-interest debts, and avoid paying more than the going rates for its long-term debts.

Callable bonds offer advantages to investors, too. To learn how you can benefit from them, click to the next article.