You may not be satisfied with the lower returns you get from savings accounts and bank certificates of deposit. Bonds issued by corporations and governments might be a good alternative because they generally pay better returns. You’ll need to be careful because bonds carry investment risks that you don’t have to worry about with insured bank deposits. Callable bonds have their own features and risks compared to noncallable bonds that you need to understand before you invest in either security.
Bonds are debt securities issued by governments and corporations. Essentially, the issuer borrows money and a bond is an IOU. Each bond has a maturity, which is the date the bond has to be redeemed, meaning the issuer has to pay back the borrowed money. The amount that must be repaid is called the face value, or par value. Callable bonds are different from noncallable bonds in that the issuer can redeem callable bonds before the maturity date.
Long-term bonds may have maturities of 10, 20 or even 30 years. Issuers sell callable bonds to avoid being locked into paying above-market interest rates if market rates fall after a bond is issued. For the investor, this makes a callable bond a riskier investment than a noncallable bond. Suppose a company sells a bond with an 8 percent interest rate and a 30-year maturity. Five years later, market interest rates are down to 6 percent. With noncallable bonds, the issuer is stuck with paying 8 percent while the bondholder -- that's you -- can fly high by collecting above-market interest. If bonds are callable, though, the issuer can exercise the call option, pay off the high interest bonds and issues new bonds at the lower market rate. That means that you, the investor, lose out just when you should be benefiting from the fruits of your investing genius.
Price and Yield
Because investors take a greater risk by purchasing callable bonds, they usually get higher yields to compensate. This means that the bond pays a higher interest rate if it is callable than if it is noncallable. If interest rates on two bonds are the same, the callable bond usually has a lower market price than the noncallable bond, which boosts its effective interest rate. Callable bonds usually include a call date as part of the bond agreement. Issuers cannot call the bond until the call date. Investors need to be wary of callable bonds that are close to their call dates; if market interest rates are lower than the bonds’ interest rate, it will be to the bond issuer’s advantage to call the bonds as soon as possible.
The main feature of noncallable bonds is that the bond’s interest rate is guaranteed until the bond matures. An investor can count on a callable bond’s interest rate only until a call date arrives. Call dates may take different forms. Some callable bonds can be redeemed at any time after a specified date. Other callable bonds can be redeemed early only on specific dates. Some callable bonds include a call premium. This is an extra amount, typically about one year’s interest, which is paid to the investor in addition to the face value if the issuer exercises the call option and pays off the bonds early.