Overview and Key Difference 2. What are Callable Bonds 3. What are Convertible Bonds 4. Callable bonds, also referred to as redeemable bonds , are a bond that can be redeemed by the issuer prior to maturity final payment date. Bonds can have maturity periods ranging from short, medium to long-term; some bonds have maturity periods exceeding 10 years.
With fluctuations in interest rates over time, if the rates have decreased since the company first issued the bond, the company will want to refinance the debt at a lower rate of interest. As a result, the company may decide to call the issued bonds and reissue them at a lower interest rate. Not all types of bonds are callable, especially treasury bonds and notes.
Most municipal bonds and some corporate bonds are callable. Companies must specify whether their bonds are callable at the time of issuance. Other related information such as whether there is a possible call option in the future should be specified at the outset. When a bond is callable, it takes place at a premium at a higher price than the issue price. Figure Interest rate fluctuations is the main reason for issuers to recall the bonds. In the case of callable bonds, the issuer may terminate the bonds before the stated expiration date, while the bondholder has the same right with convertible bonds.
In both cases, a windfall profit is possible. The bondholder of a callable bond is compensated by the issuer for an early recall.
In the case of a convertible bond, too, early termination of the bond by way of conversion only occurs if such conversion is profitable. The primary difference between callable and convertible bonds is the party that has the legal right to act.
With callable bonds, the issuing firm decides when to call the bonds, provided that the date window within which such action can be taken as specified in the prospectus has been reached. With convertible bonds, the bondholder decides when to convert the bonds. While there is a windfall profit for the bondholder in either case, the profit potential with a convertible bond is much higher.
A built-in or embedded perk that some bonds have are that they are callable, putable, or convertible. This article will describe the differences between these three provisions and discuss how they can be beneficial to the bond issuer or the bondholder. Those studying for the CPA, CFA, or any financial license exams should be able to know the differences between callable, putable, and convertible bonds. Are you studying for one of these exams? Be sure to check out the tutoring services that we offer.
Callable bonds are bonds that give the issuer the right to redeem or buy back all or part of the bond before it matures. A call provision is beneficial to the issuer because if they are able to issue bonds at a lower interest rate they can call the bonds and do so. Issuing bonds at lower interest rates simply means that it will cost the issuer less. When an investor purchases a bond in general, they are usually expecting a fixed stream of coupon payments at a stated rate as well as a return of their principal.
Because the issuer can call the bonds in the chance of lower interest rates, this exposes the bondholder to reinvestment risk: the risk that future coupon payments from a bond will not be able to be reinvested at the rate the bond was initially purchased at. The combination of the reinvestment risk the bondholder bears, and the option given to the issuer of taking advantage of lower interest rates means that callable bonds usually sell at a lower price than similar non-callable bonds.
There are three different types of callable bonds, their differences being when the issuer can buy or redeem their outstanding securities. A putable bond is a bond that gives the bondholder the ability to sell the bond back to the issuer at a predetermined price on predetermined dates.
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