Bonds are debt securities, similar to an IOU. Borrowers issue bonds to raise money from investors willing to lend them for a certain period. When you buy a bond, you lend money to a company, municipality, or the government. Bonds can be classified into term and callable bonds.
What does it mean when a bond is callable?
Term Bonds
Term bonds are debt securities paid out only at maturity or earlier with a penalty payment. The issuer of the term bond locks in the interest rates it will pay until the security matures. Whether interest rates decline or increase, the issuer will continue paying the locked-in rate until maturity. They include treasury bonds, notes, and corporate and municipal bonds.
Strengths of term bonds
- Low risk and guaranteed Interest rates:
Investors are guaranteed a fixed interest payment even when the market is volatile. - Price Appreciation:
Term bonds with many years until maturity readily respond to changes in interest rates. If interest rates decline, the relatively high yield on existing issues makes them more attractive, and investors bid up their prices. As the maturity date nears, the prices return to face value, as it’s the amount that bondholders will ultimately receive.
Weaknesses of term bonds:
- Low-interest rates:
Because the interest rate is fixed regardless of market movements, they tend to be lower. - Higher cost of debt:
Term bond issuers are disadvantaged as they may be stuck paying higher rates even when interest rates have declined.
Why is this a good choice?
Term bonds are a good choice for low-risk investors who are guaranteed a stated interest rate for security duration.
What does it mean when a bond is callable?
Callable Bonds
Also known as redeemable bonds. Callable bonds can be redeemed earlier at the issuer’s discretion before maturity. They allow companies to pay off their debt and benefit from favorable interest drops.
Most callable bonds tend to have a premium to compensate investors for additional risks. The majority of callable bonds are municipal or corporate bonds.
Strengths of callable bonds:
- Higher coupon or interest rate:
Callable bonds typically pay higher rates than non-callable bonds. - Flexible:
A business may choose to call their bond if market interest rates are lower, allowing them to reborrow at low rates that would benefit them.
Weaknesses of callable bonds:
- High-risk and yield uncertainty for the investor:
If the bonds are redeemed, the investors lose some future interest payments, known as the refinancing risk. - Limited price appreciation:
A callable bond can be forcibly redeemed well before maturity. As such, they are pegged to the redemption price much earlier. The net effect is that callable bonds enjoy less price appreciation than equivalent non-callable bonds.
Why is this a good choice?
For entry-level investors, callable bonds may be too complex to consider. They are, however, a good choice for an experienced investor. Callable bonds are the right choice for the issuer if you are looking to systematically get out of debt while taking advantage of cheaper credit.
We hope this article helped you answer the question – Bonds: Term Vs. Callable – What’s Best?
Related: Direct Credit to Customers: Is this a Risk worth taking?
References used to write this article
Chen, J. (n.d.). What Investors Need to Know Before Investing in Callable Bonds. Investopedia. (URL)
Corporate Finance Institute. (2019a, March 12). Non-Callable Bond. (URL)
DiSanto, J. (2020, November 19). How To Make Your Money Work For You: 7 Modern Methods of Investing. (URL)
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