Callable bond permit’s the issuer to redeem the bonds earlier to their original maturity date.
We can also say that, bonds which have embedded call option in them are called as Callable Bonds. This characteristic places a risk for investors but is beneficial for the issuers.
An embedded call option loots the issuer the right to call back the bond before maturity.
If interest rates drop, the issuer would be in a position to raise the same amount of loan, at a lower interest rate.
It is to the benefit of the issuer to redeem the prevailing high-cost bond before maturity and restore it with a new low cost bond.
To balancethe risk to investors, Callable Bonds regularly have high coupons and they are also valued not as per YTM but as per Yield to Call. YTC – which means the markets assume that the bond will forcibly be called back on the specified call date.
The investor in a callable bond, on the other hand, loses the opportunity to stay invested in a high coupon bond, if the call option is utilised by the issuer.
For instance, a 10-year bond may be issued with call option at the end of the 5th year such as in the SBI bond illustration below.
SBI Bonds 2011 Series 3
Issuer State Bank of India (SBI)
Credit Rating Care AAA
SBI has the option to redeem outstanding principal and interest
5 years and one day from the date of allotment
Puttable bond permits the investor the right to look for redemption from the issuer before the original maturity date.
These bonds have embedded Put options in them. Under this case, the risk is on the issuer, as the investor can, at any point of time give the bond back to the issuer and ask for his principal, prior to maturity. This would mean cash flow problems for the issuer.
Investors would apply their right to put the bond back to the issuer when interest rates start rising.
They would merely ask for their money earlier than maturity and reinvest that at a higher rate.
For instance, a 5-year bond may have a put option at the end of the 3rd year. If interest rates have risen, puttable bonds give investors the ability to exit from low-coupon bonds and re-invest money in higher coupon bonds.