Bonds that are callable can be redeemed by the issuer before the bond’s maturity date, which increases its risk relative to noncallable bonds.
However, callable bonds offer somewhat higher interest rates to investors as compensation for their higher risk.
Reinvestment risk, which affects callable bonds, is the chance that investors will have to reinvest their money at reduced interest rates if the bonds are called away.
Bonds that can be called are a wise investment when interest rates are stable.
Bonds with a call option have two possible lifecycles: one that ends at the bond’s initial maturity date and the other at the call date.
The issuer may take back the bonds from its investors at the call date. By simply repaying the investors’ money, the issuer retires (or pays off) the bond. The climate for interest rates determines whether or not this happens.
Take the case of a 30-year callable bond with a 7% coupon that is redeemable after five years as an illustration. Assume that five years from now, 30-year bond interest rates will be 5%. In this case, the debt might be refinanced at a lower interest rate, therefore the issuer would probably recall the bonds.