Callable bonds carry higher yields than otherwise similar plain vanilla bonds.
By Sunil K. Parameswaran
What is an option? It is a right given by one party to another. Subsequently, if it is profitable, the recipient will exercise the right. Else, he or she will refrain from exercising, and is empowered to do so. Bonds can come with built-in options. Let us consider callable bonds. These allow the issuer to redeem a bond prior to maturity, by prematurely returning the principal. The option is with the issuer, and consequently it must pay a premium. This will show up in the form of a lower price compared to a plain vanilla bond. Thus, callable bonds carry higher yields than otherwise similar plain vanilla bonds.
Callable bonds expose the holders to timing risk as well as interest rate risk. The former arises because the holder is never sure as to how many coupons he is going to eventually get, and when the principal will be repaid. The latter arises because such bonds will be recalled when rates are falling. This is because, in such circumstances, the issuer can recall the bonds and issue fresh securities with a lower coupon. Thus, the principal is likely to come back when market rates are low. It must be emphasized that all bonds subject the holders to reinvestment risk because the rates may be low when the coupon payments are received. It is just that, in the case of callable bonds, the magnitude of risk is greater.
In practice, when a callable bond is redeemed, a call premium of six month’s or even one year’s coupon may be paid. This is like a lollipop offered to the investor: Do not cry because I am taking the bond back, here is something to sweeten the deal.
At the time of issue, a callable will have a higher coupon compared to a plain vanilla bond with the same risk quality, because it exposes a holder to timing risk and reinvestment risk. Subsequently, if we compare a plain vanilla bond with a callable bond that is similar in all other respects including the coupon, the latter will have a lower price or a higher yield-to-maturity (YTM).
Just like the yield to maturity, we can compute a statistic called the yield-to-call (YTC) for such bonds. It is that discount rate that makes the present value of all the cash flows from the bond, equal to the dirty price, assuming that the bond is held to the call date. In practice a bond may have multiple call dates. In such situations, the market will compute the yield to call for every call date, as well as the yield to maturity. The lowest of these values is called the Yield to Worst.
A bond may be discretely callable on continuously callable. The former is callable only on certain specified dates, typically coupon payment dates, while the latter can be called at any point in time. In options parlance, the former is like a bond with a Bermudan option, while the latter is like a bond with an American option. In practice, such bonds will have a lock-in period known as a Call Protection Period. Until this period expires, the issuer cannot call back the bonds, no matter how low the yields in the market may be.
(The writer is CEO, Tarheel Consultancy Services)