Callable obligation definition

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What is a Callable Obligation?

A callable obligation is a feature attached to a debt security that gives the issuer the right to redeem the security prior to its normal maturity date. The feature typically mandates that the issuer cannot exercise this option for a number of years after the original issuance date, and also mandates that the redemption must be conducted at a price higher than the face value of the security. This feature is usually attached to a bond issuance, so that the issuer can redeem the bond if interest rates fall at some point in the future. The bond issuer then redeems the bonds and replaces them with bonds that carry a lower interest rate.

Characteristics of a Callable Obligation

Callable obligations have several distinct characteristics, which are as follows:

  • Call option for the issuer. The issuer has the right to redeem the obligation early, often at a predetermined price (the call price).

  • Call premium. Callable obligations may include a call premium, which is an extra amount paid above the face value if the obligation is called before maturity. The premium compensates investors for the risk of early repayment.

  • Call schedule. A call schedule specifies when the obligation can be called and at what price. Some callable obligations have a lockout period during which the issuer cannot exercise the call option.

  • Interest rate risk for investors. Investors face reinvestment risk because they might have to reinvest their funds at lower interest rates if the obligation is called early. Callable obligations typically offer higher initial yields to compensate investors for this risk.

  • Flexibility for the issuer. Issuers can reduce their interest expense by calling and refinancing the obligation at a lower rate. This feature is advantageous for issuers in declining interest rate environments.

  • Market value impact. Callable obligations are less sensitive to interest rate changes compared to non-callable obligations. Their potential for early redemption tends to cap price appreciation in falling interest rate environments.