Callable Security

FacebookTwitterGoogle+LinkedIn

callable security (or redeemable security) is a security with a call provision. This provides for the early retirement (“call” or “redemption”) of the security.  Redemption may be required if certain conditions are met (mandatory redemption) or it may be at the issuer’s option. The two common forms of callable securities are callable preferred stock and callable bonds.

All or part of an issuance may be called. If only part is called, the specific securities to be retired may be selected by serial number, lottery or some other mechanism.

Investors whose securities are called are paid a specified value, called the call price. For callable preferred stock or coupon bonds, the call price may be the security’s par value, or it may be a price somewhat higher than the par value. For zero-coupon bonds, the call price may be equal to or greater than the security’s book value. The difference between a security’s call price and par value (or book value) is the call premium.

There are different reasons why an issuer might call securities, so securities may be issued with multiple call provisions. Three types of call provisions are commonly encountered:

  • Optional redemption allows the issuer to call the security for any reason.
  • Extraordinary redemption primarily applies to bonds. It provides for redemption if certain specified events occur. One such event might be the destruction of facilities a bond was issued to finance. In such a case, funds for the redemption would come from an insurance policy covering the facilities. Another event might be a determination that interest payable on a municipal bond was taxable. If a specified event occurs, redemption may be mandatory or at the issuer’s option, so there is extraordinary mandatory redemption and extraordinary optional redemption.
  • Sinking fund redemption requires the issuer to periodically redeem some securities to satisfy a sinking fund provision. The issuer may retain some flexibility over the timing of redemptions.

While all of these pose risk for investors who purchase callable securities, it is optional redemption provisions that are of most concern. Issuers tend to exercise such provisions for economic purposes—and market conditions that make a redemption economically advantageous for an issuer tend to make it economically disadvantageous for investors. The most common scenario is of an issuer calling a bond after interest rates have fallen. The redemption benefits the issuer, who is able to secure new financing at lower interest rates. It hurts investors who are forced to reinvest at lower interest rates.

Securities with optional redemption provisions are issued with higher yields than comparable securities that lack such provisions. The extra yield is like an option premium compensating investors for the short call option the redemption provision represents. Optional redemption provisions may also have high call premiums. These make it desirable for the issuer to call the security in only the most favorable economic conditions—and mitigates the investors’ loss in the event that a redemption actually occurs.

Some optional redemption provisions have a declining call premium specified as a call schedule. For example, a USD1,000 par value bond might have a USD 100 call premium for its first five years, a USD 50 call premium for the next five years, and be callable at par after that. Another safeguard for investors is call protection, which limits optional redemption during the first few years of a callable security’s life. Typically, this takes the form of a prohibition against optional redemption during that period. The first call date is the earliest date on which the callable security is fully callable.

A callable security can generally be called any time after its issuance or first call date, usually with a month’s notice or so. As a practical matter, this may be limited to coupon dates or dividend dates, but some callable securities allow continuous call, which is redemption on any business day. If a security is called between coupon or dividend dates, accrued interest is paid along with the call price.

FacebookTwitterGoogle+LinkedIn
No comments yet.

Leave a Reply

Powered by WordPress. Designed by Woo Themes