Callable or redeemable bonds are bonds that can be redeemed or paid off by the issuer prior to the bonds' maturity date. When an issuer calls its bonds, it pays investors the call price (usually the face value of the bonds) together with accrued interest to date and, at that point, stops making interest payments. Sometimes a call premium is also paid. Call provisions are often a feature of corporate and municipal bonds.
An issuer may choose to call a bond when current interest rates drop below the interest rate on the bond. That way the issuer can save money by paying off the bond and issuing another bond at a lower interest rate. This is similar to refinancing the mortgage on your house so you can make lower monthly payments. Callable bonds are more risky for investors than non-callable bonds because an investor whose bond has been called is often faced with reinvesting the money at a lower, less attractive rate. As a result, callable bonds often have a higher annual return to compensate for the risk that the bonds might be called early.
There are three primary types of call features, including:
- Optional Redemption. Allows the issuer, at its option, to redeem the bonds. Many municipal bonds, for example, have optional call features that issuers may exercise after a certain number of years, often 10 years.
- Sinking Fund Redemption. Requires the issuer to regularly redeem a fixed portion or all of the bonds in accordance with a fixed schedule.
- Extraordinary Redemption. Allows the issuer to call its bonds before maturity if certain specified events occur, such as the project for which the bond was issued to finance has been damaged or destroyed.