What are callable bonds?

A bond is a fixed-income instrument.

It is a stream of cash flows that the issuer agrees to pay to the lender within a specified time.

It is a fixed contract.

If DropoutEdu issues a bond with a face value of $1,000, a coupon rate of 5% paid annually, and a 5-year maturity, this means that investors will collect $50 each year and the $1,000 back at the end of the 5 years.

But what happens if the current interest rate environment was very high.

Say, 10%.

You may ask, then why issue debt?

Well, sometimes there’s no choice. Companies may not have the cash on hand in order to pay off the debt in full.

So, the company must get new debt financing in the higher interest rate market.

But, with this in mind, DropoutEdu wants some flexibility.

It knows that rates will likely fall in a few years.

So, to take advantage of that information, DropoutEdu wants to pay back lenders early.

So, what’s the solution?

Issue a callable bond. A bond that can be called back (aka repaid early).

This allows the firm to re-borrow at a lower interest rate in the future.

But, the lender will not be as well off in this case because they do not get the interest payments for the remainder of the period after the bond is repaid.

So, investors will pay less for such bonds.

This means that the call optionality costs the firm money.

But, if the interest rate risk outweighs the cost of issuance, it makes sense for the firm to issue a callable bond.

Bottom-line? Callable bonds provide issuers flexibility, which is especially useful in high interest rate environments.