Callable bond
A bond that the issuer may redeem before its original maturity date — typically exercised when interest rates fall, leaving the investor to reinvest at lower rates.
In plain language
A plain bond runs to its maturity date. A callable bond carries a call option in the bond contract that lets the issuer repay it early, on the terms set at issue.
The option belongs to the issuer, so it will be used when it suits the issuer. That is almost always when interest rates have fallen: the issuer repays the expensive old bonds and borrows again more cheaply. The investor gets the money back at exactly the moment when reinvesting it earns less.
How it works
The workbook's description (section 2.4.2, "Other Variations in Bond Structures"). Callable bonds let the issuer alter the tenor of the security, giving more flexibility in managing debt capital. If rates decline, the issuer can redeem the callable bond and re-issue fresh bonds at a lower rate; the investor loses the opportunity to stay invested in a high-coupon bond.
The workbook's illustration (Box 2.2):
| XYZ Bonds Series 3 | |
|---|---|
| Issuer | XYZ Bank |
| Rating | Care AAA |
| Face value / issue price | Rs 10,000 / Rs 10,000 |
| Coupon | 9.75%, annual |
| Tenor | 10 years |
| Call option | XYZ may redeem outstanding principal and interest after 5 years and one day from allotment |
The risk this creates is named in section 2.4.4 as call risk: the investor may have planned to hold to maturity, but the issuer calls the security; securities are usually called when rates decline; as a result, investors are forced to reinvest at lower rates.
A worked example
Illustrative rates. Anita invests Rs 10 lakh in 100 of the XYZ Bank bonds above — 9.75 per cent for 10 years, callable after 5 years.
Annual coupon income = Rs 10,00,000 × 9.75% = Rs 97,500
Five years later comparable bonds yield 7.5 per cent. XYZ Bank calls the bonds and re-borrows at the lower rate. Anita gets her Rs 10 lakh back and reinvests at 7.5 per cent.
New annual income = Rs 10,00,000 × 7.5% = Rs 75,000
Income lost per year = Rs 97,500 − Rs 75,000 = Rs 22,500
Over the 5 years the bond would have run = Rs 1,12,500 (before any reinvestment)
Now reverse it. If rates had risen to 11 per cent, XYZ Bank would have no reason to call — it would keep paying 9.75 per cent — and Anita would be the one stuck below market. The option only ever works in the issuer's favour.
Why NISM asks about it
Chapter 2 (Securities: Types, Features and Concepts of Asset Allocation and Investing) covers callable bonds among the variations in bond structures (section 2.4.2, with Box 2.2) and call risk among the risks of debt securities (section 2.4.4). Questions ask who holds the option, when it is exercised, and what risk it creates for the investor.
Common exam traps
- The call option belongs to the issuer, not the investor. The investor's early-exit right is a put.
- Calls happen when rates fall. An issuer does not repay cheap debt early.
- Call risk is a reinvestment problem — the investor must reinvest at lower rates — closely related to reinvestment risk, but specific to callable securities.
- The call date is fixed in the terms — in Box 2.2, after 5 years and one day from allotment, not at any time the issuer likes.
- Do not confuse a callable bond with a call option on a share or index, which is an exchange-traded derivative giving its buyer the right to buy.
Where this is taught
- Series XXI-B · Chapter 4: Investing in Fixed Income Securitiesintroduced here
- Series X-A · Chapter 9: Investing in Fixed Income Securitiesintroduced here
- Series XXI-A · Chapter 4: Investing in Fixed Income Securitiesintroduced here
- Series XII · Chapter 2: Securities: Types, Features and Concepts of Asset Allocation and Investingintroduced here
Related terms
- Call riskThe risk that a bond is called — redeemed by the issuer before maturity. Most prevalent when interest rates fall, and it usually goes hand in hand with reinvestment risk.
- Reinvestment riskThe risk that the coupons or other intermediate cash flows from an investment have to be put back to work at a lower rate than the original investment earned, pulling the total return below the promised yield.
- Yield to MaturityThe single discount rate at which a bond's future coupons and redemption amount add up to exactly its market price today — the return you actually earn if you hold it to maturity.
- Coupon rateThe rate of interest a bond pays, applied to its face value and never to its market price — which is why the coupon tells you the cash flow but not the return.
- Puttable bondA bond that gives the investor the right to seek redemption from the issuer before maturity — useful when interest rates have risen and better-paying bonds are available.
- IndentureThe legal agreement between a bond issuer and its bondholders setting out every term of the debt — par value, coupon, maturity, collateral, seniority, options and covenants.