The Dangers of Callable Bonds

A callable bond may offer increased yield over a non-callable bond, but you should understand the dangers. It is precisely because of these risks that callable bonds offer enhanced yields. This is typically known as a call premium that the issuer is willing to pay for the right to call the bond at its discretion.

Downside to the Investor

When a bond is callable, it means that under certain circumstances the issuer may return the principal on the bond and stop making interest payments. The specific terms vary from bond to bond, but they are always favorable to the issuer. If the bond is called, it means that there is an advantage to doing so.

The danger an investor faces is that if interest rates rise, the bond will not be called because the company will gladly pay the lower rate at which the bond was issued. If, however, rates fall, the issuer will return your money and issue new bonds at the now lower rates. The danger is that once your money is returned, you will have to invest it at the lower rate, known as re-investment risk. Callable bonds usually carry a call premium (enhanced rate) to offset this danger, but if the rate change is significant, the premium will not protect you from these dangers.

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