When a borrower issues bonds, it generally makes interest payments to the investor throughout the life of the bond and repays the full face value of the bond on its maturity date. But in the case of callable bonds, an issuer has the right to redeem the bond (repay the principal) prior to the maturity date. When this happens, the borrower is no longer required to make interest payments to investors after the call date.
When callable bonds are issued, a call price, or price for early redemption, is set. This price can be the par value of the bonds, or it can be set higher or lower than par value. In some cases, especially in taxable bonds, a bond may have a make-whole call provision. This requires the borrower to make a lump-sum payment to the investor for both the principal and the net present value of the future coupon payments that would have been made if the borrower had not redeemed the bond early.
Example:
Suppose a municipality issues $1,000,000 of bonds callable in five years with a 5.00% annual interest rate and a 10-year term.
Over the next decade, the municipality is scheduled to make $50,000 per year in interest payments on the bonds, for a total of $500,000. Instead, the municipality decides to redeem the securities after just five years. It repays the full $1,000,000 of bond principal in five years and saves $250,000 in future interest payments.A lease can be for any term, but a lease must have a term over a definite period of time with a particular starting and ending date.
Callable securities give borrowers flexibility. If a borrower’s credit rating has improved since its last bond issue or general market interest rates have decreased, the borrower can rely on a call option to redeem bonds early and issue new bonds at a lower interest rate.
Borrowers, generally, have to sell callable bonds at a cheaper price than non-callable bonds since the investor takes on the risk of not receiving the interest payment throughout the life of the bond issue and also risks receiving the par value of the bond earlier in a lower interest rate environment. While selling a callable bond can save the borrower money if the call option is utilized, if the bond is not called and the borrower issued the bond at a yield higher (i.e., the borrower received less money upfront) than if they issued a non-callable bond, they would lose money in the long run.