Callable Bonds Term Paper Example | Topics and Well Written Essays - 3000 words

Callable Bonds - Term Paper Example There are different reasons as to why companies issue callable bonds, as noted by Frykman and Tolleryd, one of the reasons as to why companies issue callable bonds is because of their hedge interest rate (173). The point is that, the moment interest rates reduce, the issuing companies can then repay the bonds at lower interest rates. This paper aims at examining callable bonds. Overview As explained by Le callable bonds allows those borrowing the option of re-investing if the interest rates reduces (4). This implies that companies are able to hedge against likely reduction of interest rates in future. It is because of this aspect tha makes callable bonds to be prefered by many investors particularly before 1990s. In deed, before 1970, nearly all companies issued bonds that had were callable. But, as from 1970 to 1990, callable bonds being issued reduced to about 80%. This was attributed to developents that had taken place within the interest rate derivaive markets over that period. P resently, the number of callable bonds on the market has greatly reduced accounting for less than 30%. According to Le the reason for this reduction is the fact that, it has become easier for companies to hedge against the interest rate risks (4). Explaining callable bonds When a company issues a bond, it has to make a critical decision regarding the type of bond it will issue, if it will be a callable bond or a regular one. In defining a callable bond Brigham and Houston states that callable bond, also known as redeemable bond is a kind of bond that permits the issuing firm to retain the benefit of trading in the bond at a certain time before the maturity date (220). This implies that the issuing firm retains the right of buying back the callable bond, though it is not obligated to do that. Basically, the bonds are not in actual sense bought back by the issuing firm; rather the firm cancels them immediately. When recalling the callable bonds, the issuing firm has to pay more than t he par price. In some cases, for example in high-yield debt industry, the call premium could be considerable high. Therefore, the issuing firm has a choice, of either paying a higher premium or waiting until the bonds mature. Brigham and Houston notes that supposing the interest rates prevailing in the market go down at the time of calling back the bonds, then the issuing company will be in a position to refinance its debt cheaply (220). Accordingly, as the interest rates reduce, the value of the bonds increases, thus, it is beneficial to re-buy the bonds at their par value. When callable bonds are used, the investors are given the advantage of a higher token or value, as opposed to what they have gained with regular bonds. However, when the interest rates reduce, the issuing firms will likely recall the bonds and just invest them at interest rate is low. The moment a company has recalled the bond, the company can as well reissue the similar bonds at a much lower interest rate. This process of reissuing bonds to save money on the interest payment is referred as refunding. Brigham and Houston notes that before the bonds are recalled, the bond holders are informed by a letter, one of the agreements when investing in a callable bond (221), is that the investors agree that the bonds can be bought back and the investors should be ready to sell the bonds. However, companies recalling the bonds