Callable bond

economic-dictionary

A callable bond is one that carries an implicit right on the part of the issuer to buy back the bond from the holder on a predetermined date. This, at a certain price called the rescue price.

Quiet bonds are typically issued when a company expects that macroeconomic conditions will improve over time. This will allow them to be able to finance themselves at a cheaper interest rate.

Callable bonus example

Suppose a 10-year bond that is callable at par (100% of the nominal value) redeemable at 5 years and with an interest rate of 10%. Suppose that after 5 years, the situation of the company improves. The interest rates at which the bond of this company is traded become 6%. The company will buy back the bonds as they can be refinanced at the prevailing interest rate, at a cheaper rate.

Conversely, if the interest rate increases because the company's situation worsens, the company will not redeem those bonds. He will not rescue them, since if he bought them back it would cost them more to refinance than that initial 10%.

Why are quiet bonds bought?

In principle, one might think that the company is the one that always wins. If the interest rate falls, having the right to purchase, the company repurchases those bonds and refinances itself at a lower price. On the contrary, if the interest rate rises, you do not exercise your right.

However, these types of bonds have an attractiveness for the investor. Since the company, in principle, has more advantages, these bonuses are better paid. If a normal 10-year bond gives 4% per year, a silent bond will certainly give more than 4%. Otherwise, there would be no incentive for investors.

The convexity of a callable bond

As long as the price of the bond is above the purchase price 'P *', the convexity will be negative. In other words, as the yield on the bond decreases, the price increases at a slower rate. We must remember that it is the issuer that reserves the right to buy back the bond. If you can finance yourself cheaper again, you will exercise your right.

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