After a company or municipal government has sold a bond, it is obligated to pay interest on the bond until the bond matures, which may be for many years. Some bonds include a callable or redeemable feature that lets the issuer pay off the bond without waiting for the maturity date. Often the call provision requires the bond to be redeemed at higher value than the face amount.
Bond Call or Redemption
When a company issues a long-term bond, it is making a commitment to regularly pay the stated interest on that bond until the bond reaches maturity and the face value is paid out to the investor. With a longer term bond maturing in 20 or 30 years, the issuer may want to give itself a way to pay off the bonds early. A call or redemption feature will be included in the bond prospectus to allow the issuer to redeem the bonds at an earlier date. The redemption feature gives the issuer flexibility that could be a detriment to investors who own the bonds.
Premium Call Price
In many cases, the call or redemption feature on a bond requires the issuer to pay a "premium" to the face value if it exercises the redemption option. For example, a 20-year bond may be callable after five years with a redemption value of 105. Bond prices are quoted as a percentage of the face value, so if this bond was redeemed, an investor with a $100,000 face value bond would have receive a premium redemption value of $105,000. The premium redemption is a provision of the bond and the issuer cannot offer a lower price.
Reason for Redemption
The usual reason for an early call is because the issuer is paying a high rate of interest, and if the bonds are redeemed, new bonds can be sold at a lower rate. Investors will be required to give up their high-yield bonds and probably have to reinvest the proceeds at a lower rate. A premium price on a redeemed bond takes away some of the sting of having a high-rate bond called in by the issuer.
Evaluating Redeemable Bonds
If your broker shows you a redeemable bond as a potential investment, the broker will quote a yield-to-call as well as the yield-to-maturity. The yield-to-call will include the added return from the premium call price. The bond should be evaluated on the lowest of the two yields, often referred to as the yield-to-worst, as in worst-case scenario. If you really need to have your money invested for a longer period, callable or redeemable bonds may not be the best investment choice.
Tim Plaehn has been writing financial, investment and trading articles and blogs since 2007. His work has appeared online at Seeking Alpha, Marketwatch.com and various other websites. Plaehn has a bachelor's degree in mathematics from the U.S. Air Force Academy.