When Would a Bond Be Called?

by Ciaran John

    Economic downturns, changes in credit ratings and project failures are among the many reasons why an entity may call in a bond. Federal bonds are generally non-callable; however, municipal bonds, corporate bonds and mortgage bonds often include call provisions. Higher-than-average yields make callable bonds attractive to investors, but prospective buyers need to inquire about the call in features.

    Callable Bonds

    Bonds are loan agreements involving creditors and borrowers. Cities and corporations issue bonds with terms ranging from six months to 30 years. The bond issuer pays interest to the bondholders for the duration of the bond's term. Typically, the interest rate is fixed for the entire term. A call feature enables the bond issuer to pay off the debt prior to the end of the term. When the call feature is activated, bondholders receive a return of premium as well as any interest that has accrued. Investors usually demand higher-than-average yields on callable bonds; the additional interest offsets some of the risk associated with lost income if the bond is called in.

    Economic Downturn

    During economic downturns, the Federal Open Market Committee usually lowers the target rate for interbank lending. This means it becomes less expensive for banks to borrow money and these savings are passed onto borrowers. In falling rate environments, rates paid on everything from annuities to newly issued bonds begin to drop. In such an environment, a bond issuer can effectively refinance an existing debt by calling in a high rate bond and then issuing a new bond with a lower interest rate. It's the same principle that drives homeowners to refinance mortgage debt when rates begin to fall.

    Credit

    Start-up businesses have a high failure rate when compared with larger, well-established firms. Consequently, small companies typically have to pay higher rates on loans and bonds than more established firms. Credit rating agencies regularly review the finances of bond issuers, including corporations and municipalities. Over the course of time, an entity can increase its credit rating by balancing its books and making debt payments on time. The higher an entity's credit rating, the more cheaply and easily it can borrow money. Therefore, many start-up firms issue callable bonds so that these debts can be refinanced with lower-cost bonds once the firm has improved its credit rating.

    Projects

    Municipalities often issue bonds to finance public works projects such as toll roads, schools and sewage plants. However, newly elected officials may decide to scrap projects that were started by the previous administration. In such instances, the municipality may call in the project-related bonds rather continue to pay interest on debt related to the abandoned project. Corporations call in project-related bonds for the same reason. However, many project-related bond contracts include clauses that prevent the issuer from calling in the bond for a set number of years.

    Photo Credits

    • Jupiterimages/Photos.com/Getty Images

    About the Author

    Ciaran John began writing in 1994 with contributions to "The Hourly Press" and "The Sawbridgeworth Observer," and has since written for many online and print publications. He has 12 years experience working for financial services companies as a business banker, lender and investment representative and spent four years working in human resources.

    Zacks Investment Research

    is an A+ Rated BBB

    Accredited Business.