The defining characteristic of a callable bond is the issuer's ability to cancel the bond -- and thus stop paying interest on it -- simply by refunding bondholders' money. By contrast, a noncallable bond obligates the issuer to keep paying interest for the full term of the bond, all the way to the maturity date.
A basic corporate or government bond has a face value, a maturity date and an interest rate, often called the "coupon." You buy the bond at face value, then receive the coupon rate every year until the maturity date, at which point you get the face value back. For example, if you bought a $5,000 bond with a 10-year maturity and a 4 percent coupon, you'd collect $200 a year for 10 years, then get your $5,000 back. Your $5,000 investment would have turned into $7,000.
Interest Rate Fluctuations
When interest rates are falling, bond issuers can encounter a problem. Say a company issues a 10-year bond with a 4 percent coupon. A year after it sells the bond, interest rates begin to drop, to the point where new bonds are being issued with only a 2 percent coupon. The problem is, the issuer is stuck paying 4 percent on those old bonds every year until maturity. However, if the original bonds were callable bonds, the issuer could just send every bondholder a check, retire the bonds and issue a whole new series of bonds, all of them at 2 percent interest.
Noncallable bonds have only one date that matters: the maturity date. Callable bonds, also known as redeemable bonds, have two key dates. There's a regular maturity date, which will remain in effect if the coupon rate of the bond is in line with, or lower than, current interest rates. Then there's the callable date, the point at which the issuer will be permitted to "call in" the bonds if interest rates have dropped below the coupon rate. A bond might have a 20-year maturity but a five-year callable date.
Callable bonds give issuers a hedge against falling interest rates, but that hedge comes at investors' expense. People who buy callable bonds are exposed to risk -- not necessarily the risk of losing the money they paid for the bond in the first place, but the risk that the bond will be called so they won't realize the gains they had been expecting. To compensate for that risk, callable bonds generally carry a higher interest rate than noncallable bonds. Also, some callable bonds pledge to repay more than the original face value if called. An issuer might sell a callable bond for $5,000 with the condition that the bondholder will be repaid $5,250 in the event of a call.
Cam Merritt is a writer and editor specializing in business, personal finance and home design. He has contributed to USA Today, The Des Moines Register and Better Homes and Gardens"publications. Merritt has a journalism degree from Drake University and is pursuing an MBA from the University of Iowa.