Callable Bonds

Callable bonds are a type of debt security that allows the issuer the right to redeem the bond from the bondholders before its maturity. To compensate for this risk of early redemption, callable bonds usually offer higher coupon rates. Understanding bond’s call terms, coupon rate payments and personal financial goals is crucial before investing in callable bonds.

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What are Callable Bonds

A callable bond is a debt security that can be redeemed or called back by the issuer before its stated maturity date at a predetermined price and call date. The predetermined price that the issuer has to pay to call a callable bond is known as the call price. These bonds come with an initial lock‐in period (also known as call protection) during which the issuer cannot call back the bonds. The issuer exercises this buy back option usually when interest rates fall, allowing them to refinance debt at a lower cost.

Call provisions allow the bond issuer to retire the high yield bonds and sell low rate bonds in a bid to lower debt cost. As these bonds give issuers the flexibility to repurchase it, investors face the reinvestment risk as they have to reinvest the principal at the lower yields.

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Key Terms to Know Before Investing in Callable Bonds

Call Price: The price (usually face value plus call premium) that the issuer has to pay to call a callable bond.
Call Date: The date when the issuer has the right to redeem the bonds before the maturity date.
Call Protection Period: Initial lock in period during which the bond cannot be called.
Yield to Call: The rate of return an investor would earn if an investor buys a callable bond at its current market price & holds it until the call date.

How Do Callable Bonds Work

When an issuer invests in a callable bond, they receive periodic coupon payments just like a regular bond. After the call protection period, if market interest rates fall, the issuer has the right to “call back” the bond and repay the principal (plus premium) to the bondholders before the maturity date. To compensate for the risk of early redemption, issuers usually offer callable bonds at higher coupon rates.

Example

In 2019, ABC company issued a callable bond with a maturity period of 7 years (2026). The bond is callable anytime after the maturity duration of 5 years, i.e., 2024. The bond has a coupon rate of 11%. In 2025, the interest rates fall and therefore the issuer can issue new bonds at a coupon rate of 9% and call back the earlier issue, reporting more expensive 11% bonds.

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Risks Associated with Callable Bonds

Call Risk: The primary risk of callable bonds is the call risk, i.e, your bond can be redeemed anytime after lock in period, when interest rates fall.
Reinvestment Risk: As the issuer redeems the bonds before they mature, the investor then receives their principal back sooner than expected and is forced to reinvest that money in a lower coupon rate environment.
Uncertainty of Holding Period: Bondholders are not sure how long they will hold the bond and receive the promised coupon rate till maturity.
Loss of Higher Yield: The investor loses the higher coupon payments they expected to receive until the original maturity period of callable bonds.

Important Things to Consider Before Investing in Callable Bonds

Before investing in callable bonds, one should understand the reinvestment risk associated with the bond.
Check the credit rating and financial statements of the bond issuer. The lower the credit rating and financial statements, the higher the risk involved. Invest in bonds according to the risk appetite, not just returns.
Consider diversifying your portfolio across issuers and sectors. This can help reduce potential losses as concentrated exposure to a single industry or issuer increases risk.
Know the tax implications of callable bonds before investing in them.
Read the terms and conditions of the callable bonds. Check the frequency of coupon payments, call price, call protection period and call date, etc, before you start investing in a callable bond.

Callable Bonds vs Puttable Bonds

Differentiation Factor	Callable Bonds	Puttable Bonds
Right of early redemption	Callable bonds give the issuer the right to call the bonds at a specified price and date before the maturity period.	Puttable bonds give the right to bondholder to sell the issue back to the issuer at a specified price on a specified date.
Exercise Option	Call option is exercised by the issuer, usually when interest rates fall, to refinance debt at a lower cost	Put option is exercised by the investor when market interest rates rise (allowing the investor to exit and reinvest at a higher rate).
Coupon Rate	Generally, offer a higher coupon rate compared to non callable bonds to compensate bondholders for the risk of early redemption.	Generally, offer a lower coupon rate compared to non puttable bonds because the investor receives the added flexibility to sell the issue back
Obligation of early redemption	The bondholder is obligated to sell the bonds	The issuer is obligated to repay the investment
Benefit to the other party	Bondholder receives call premium	The issuer pays a lower interest rate

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Taxation of Callable Bonds in India

The taxation on callable bonds involves two components, i.e., capital gains and interest income.

Capital Gains

Capital gains are taxed depending on how long an investor has held the bonds. Short Term Capital Gains (STCG) arise when an investor has held bonds for a duration of up to 12 months. It is taxed according to the tax slab rate of an investor. On the other hand, Long Term Capital Gains (LTCG) arise when an investor has held bonds for a duration of more than 12 months. It is taxed at 12.5% for listed bonds (without indexation benefit) and 20% for unlisted bonds.

Interest Income

The interest income earned from a callable bond is taxed as per the income tax slab of the bondholder.

How to Buy Bonds through Paisabazaar?

Get up to 13.25% from bonds in 5 simple steps

Step 1: Login to your Paisabazaar account

Step 2: Select the Bonds

Step 3: Complete the KYC process

Step 4: Enter bank details

Step 5: Link your demat account

FAQs

Companies issue callable bonds to manage their debt and reinvest bonds at lower yields during a falling interest rate regime. This helps companies to reduce their borrowing costs and to adjust their capital structure based on a changing market environment.

Callable bonds allow the issuer to call back and repay the bond before maturity at a call price. Non-callable bonds do not have call provisions and continue until maturity. As callable bonds have the risk of early redemption, the issuer of such bonds usually offers higher coupon rates than non-callable bonds.

Callable bonds can be a suitable investment for investors seeking higher interest income and understanding interest rate fluctuations.

Callable bonds carry certain risks for investors. The primary risk is call risk, where the issuer calls the bond early during interest rates fall which directly leads to reinvestment risk. The reinvestment risk refers to when an investor has to reinvest the returned principal amount at lower interest rates.

Callable bonds usually offer higher interest rates compared to non-callable bonds or puttable bonds to compensate investors for the risk of early redemption.