A callable bond is a type of bond which gives its issuer (the borrower) the option to repay the principal before the bond term ends. The term is synonymous with redeemable bond.
Companies or government agencies can avoid paying more interest than necessary by issuing callable bonds which can be terminated ahead of schedule if average interest rates fall well below the interest rates paid by their bonds.
Issuing callable bonds also gives issuers the option of saving on coupon payments by amortizing their loans ahead of schedule.
Example of a callable bond:
In order to raise capital to fund its growth, a company issues 500,000 francs worth of callable bonds with a 5% annual interest rate and a 10-year term. If the company were to pay out the 5% annual coupon to bond holders every year throughout the full 10-year term, the cost of the loan would come to 250,000 francs (5% of CHF 500,000 = CHF 25,000 x 10 years).
However, 6 years later, strong sales result in the company having a surplus of cash which it can use to repay its debt. The company calls on its callable bonds and repays the 500,000 francs of bond principal to bond holders. By repaying the loan ahead of schedule, the company reduces the total cost of the loan to 150,000 francs – a saving of 100,000 francs.
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