Investments, tenth edition

   Callable Bonds 

 You know from Chapter 14 that many corporate bonds are issued with call provisions enti-

tling the issuer to buy bonds back from bondholders at some time in the future at a specified 

call price. The bond issuer holds a call option with exercise price equal to the price at which 

the bond can be repurchased. A callable bond arrangement therefore is essentially a sale of a 

 straight bond  (a bond with no option features such as callability or convertibility) to the inves-

tor and the concurrent issuance of a call option by the investor to the bond-issuing firm. 

 There must be some compensation for the firm’s implicit call option. If the callable 

bond were issued with the same coupon rate as a straight bond, it would sell at a lower 

price than the straight bond: the price difference would equal the value of the call. To sell 

callable bonds at par, firms must issue them with coupon rates higher than the coupons 

on straight debt. The higher coupons are the investor’s compensation for the call option 

retained by the issuer. 

  Figure  20.11  illustrates this optionlike property. The horizontal axis is the value of a 

straight bond with otherwise identical terms to the callable bond. The dashed 45-degree 

line represents the value of straight debt. The solid line is the value of the callable bond, 

and the dotted line is the value of the call option retained by the firm. A callable bond’s 

potential for capital gains is limited by the firm’s option to repurchase at the call price.  

 How is a callable bond similar to a covered call strategy on a straight bond? 

 CONCEPT CHECK 

20.6 

 The option inherent in callable bonds actually is more complex than an ordinary call 

option, because usually it may be exercised only after some initial period of call protec-

tion. The price at which the bond is callable may change over time also. Unlike exchange-

listed options, these features are defined in the initial bond covenant and will depend on 

the needs of the issuing firm and its perception of the market’s tastes.   

 Suppose the period of call protection is extended. How will the coupon rate the 

company needs to offer on its bonds change to enable the issuer to sell the bonds 

at par value? 

 CONCEPT CHECK