|Bonds that are callable include an option that permits the issuer to
mature the debt at an earlier date than the final stated maturity date.
Callable bonds are advantageous to the issuer of the security and therefore
offer a higher yield level than comparable non-callable securities.
The issuer will take advantage of the call option and mature the bonds
early if interest rates fall between the time the bonds are issued and
the call date. Why? Because the company can then reissue the
debt for the remaining maturity at a lower interest rate and save on what
their original interest costs would have been. If interest rates
rise and the bond is not called, the investor in the bond will have the
advantage of earning a higher yield level until the maturity date than
if the same bond was bought as a non-callable security. The dollar
price of the bond will determine whether the bond is trading to the call
date or to maturity; bonds trading at a discount to par will generally
trade to the maturity date and bonds trading at a premium will trade to
the call date.
One of the main difficulties for fixed income portfolio managers in managing bonds with call dates is the issue of maintaining a set duration, or level interest rate exposure, for the portfolio because of duration drift. As interest rates fall, in particular, callable bonds will begin to start trading to the shorter call date instead of their maturity date, and will therefore experience a shortening of their duration. If interest rates are falling and bond prices rising, bond managers will want to have the longest duration possible in their portfolio to participate in the price appreciation; just the opposite of what occurs. This is another way of showing that callable bonds place the option benefit in the hands of the issuer and not the investor.