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Bond Basics: Callable Bonds

written by: Ashwin Satyanarayana•edited by: Jason C. Chavis•updated: 6/28/2011

It just takes a trigger to shoot; a finger to stop a war and a kind word to make someone's day and all you need to lose your shirt with wild interest rate fluctuations is an option called as " call" which is with all callable bonds. So what is this option? How does it affect an investor? Read on.

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    Bonds come with a face-value and a coupon rate (which specifies what percentage of the the face-value you would be paid) in certain amount of pre-arranged time,called as maturity date. The question that immediately comes to the fore is: If interest rates fluctuate all the time, what will be left of your money by the time the maturity date comes up (5 years, 10 years, 15 years or 30 years)?

    Consider this example, if you own a $100 bond with a coupon rate of 6%, and the Interest rate rises by 1 percentage point, then a 1 year maturity bond becomes worth $99.05 while a 10 year maturity bond is worth $92.89 and a 30 year maturity bond is worth $87.53.Conversely, a decrease in 1 percentage point (given the same $100 bond with 6% coupon rate) would make a 1 year maturity bond worth $100.96,a 10 year maturity bond worth $107.79 and a 30 year maturity bond worth $115.45.

    It is now clear from the example that longer the maturity of the bond is, the more you would end up losing or gaining on an interest rate move.

    Call Provision Becomes The Monkey Wrench

    If you intend to buy-and-hold until maturity, interest rates can be turn real nasty and ruin your nest egg totally. If you own a bond that pays you 9 % over a 30 year maturity, and after certain number of years, the Interest rates plummet to say 6%, the company that has issued the bonds has a provision called as “ call” , even before they mature. The company would like to do that if the interest rates plummet to save on high interest costs that now come by (they are paying out 9% to you while the prevailing Interest rate is only 6%). So, technically speaking, when you purchased the bond at 9% and the interest rates are now 6%, you could be profited if you could sell it over the counter. But then, when a company places a call provision, you would be forced to make do with the face value,which the company is obliged to pay if it calls in the bond.

    Before you buy a bond, look to see if it has a call provision.If it does, look into the conditions upon which the company can call back its bonds and what price it is willing to pay you then.

    Callable bonds usually provide a higher Interest rates than normal bonds because of the slightly higher risk associated with the fact that these bonds can be called back under certain conditions. In cases where you are looking to purchase one, look for the Yield to call, which according to Investopedia isThe yield of a bond or note if you were to buy and hold the security until the call date. This yield is valid only if the security is called prior to maturity. The calculation of yield to call is based on the coupon rate, the length of time to the call date and the market price”.