Callable Bond Pricing

A callable bond is one which the issuing company can call, or pay off, before the bond's actual maturity, or due date. This benefits the company rather than the bond holder. For instance, if the issuing company has issued bonds that are paying 6% interest, but then the economy starts to decline and banks start offering loans for 4%, the company can refinance and pay a lower interest rate. They do this by calling in their original 6% bonds and paying them off at their face value before they reach full maturity, thereby not having to pay interest on them any longer. Most companies pay off their callable bonds at a higher price than their actual face value in order to compensate the investor for lost future earnings. The companies are then free to issue new bonds at a lower rate, or take a loan from a bank at a lower rate. This can be a problem for the bond holder because if the bond holder was counting on the 6% interest rate payment for the life of the bond, when the bond is paid back early, he'll get no subsequent interest payments. He can, of course, re-invest the money, but it is unlikely that he'll receive a high interest rate from any other bond issuer if the general interest rates are falling.

For most entry-level investors, callable bonds may be too complex to consider buying because the prices of callable bonds in the secondary markets move differently from the prices of other bonds. For example, when interest rates fall most bond prices rise, but callable bond prices actually fall as interest rates fall, which is a phenomenon called price compression.

Callable bonds have some good points such as they pay higher interest rates that normal bonds pay in order to compensate for the additional risk. An experienced investor can analyze the economy and decide if he thinks that the current interest rates will decline or increase. If it seems they will increase, then callable bonds have very little chance of being called. But if the economy looks poised to decline and interest rates fall, then callable bonds are not a very secure investment.