Callable vs Convertible Bonds What’s the Difference?

The primary difference between callable and convertible bonds is the party that has the legal right to act. With convertible bonds, the bondholder decides when to convert the bonds. In the case of callable bonds, the issuer may terminate the bonds before the stated expiration date, while the bondholder has the same right with convertible bonds.

  1. If the option holder decides to use his right, we say that he exercises the option.
  2. The conversion ratio is the number of shares of stock that can be converted for each convertible security.
  3. Thus, the issue would need to be called in order to seek new financing.
  4. If the bonds are redeemed, the investors will lose some future interest payments (this is also known as refinancing risk).

Callable bonds and convertible bonds are both types of corporate bonds that offer unique features to investors. Callable bonds give the issuer the right to redeem the bond before its maturity date, usually when interest rates have fallen. This allows the issuer to refinance at a lower interest rate, but it can be disadvantageous for bondholders as they may lose out on potential interest income. On callable bond vs convertible bond the other hand, convertible bonds provide the bondholder with the option to convert the bond into a predetermined number of the issuer’s common stock. This feature allows investors to benefit from potential stock price appreciation while still receiving regular interest payments. Overall, callable bonds offer flexibility to the issuer, while convertible bonds provide flexibility to the investor.

Interest rates and callable bonds

The bondholder must turn in the bond to get back the principal, and no further interest is paid. Sinking fund redemption requires the issuer to adhere to a set schedule while redeeming a portion or all of its debt. On specified dates, the company will remit a portion of the bond to bondholders. A sinking fund helps the company save money over time and avoid a large lump-sum payment at maturity. A sinking fund has bonds issued whereby some of them are callable for the company to pay off its debt early. Fixed income securities, such as bonds, are often overlooked because their investing counterpart, equities, are often viewed as more Wall Street-esque and tend to steal the show.

The bondholder of a callable bond is compensated by the issuer for an early recall. In the case of a convertible bond, too, early termination of the bond by way of conversion only occurs if such conversion is profitable. The largest market for callable bonds is that of issues from government sponsored entities. In the U.S., mortgages are usually fixed rate, and can be prepaid early without cost, in contrast to the norms in other countries. If rates go down, many home owners will refinance at a lower rate. By issuing numerous callable bonds, they have a natural hedge, as they can then call their own issues and refinance at a lower rate.

Convertible bonds can usually be purchased through an investment advisor or brokerage that specifically offers this type of investment class. Rebecca Baldridge, CFA, is an investment professional and financial writer with over twenty years of experience in the financial services industry. She is a founding partner in Quartet Communications, a financial communications and content creation firm. After the call protection period, the call schedule within the bond debenture states the call dates and the call price corresponding to each date.

How to choose a bond broker

A put option gives the option buyer a right to sell an underlying asset in the future at a specified price to the seller of the option. The seller of a put option is obliged to buy the underlying on the option buyer’s request. A call option gives the option buyer a right to buy an underlying asset in the future at a specified price from the option seller. In other words, the option seller is obliged to sell the underlying on the buyer’s request.

What you should know before buying callable bonds

Convertible bonds are hybrid securities, meaning that they offer some of the characteristics of both fixed income and equity investments. Let’s say Apple Inc. (AAPL) decides to borrow $10 million in the bond market and issues a 6% coupon bond with a maturity date in five years. The company pays its bondholders 6% x $10 million or $600,000 in interest payments annually. A callable—redeemable—bond is typically called at a value that is slightly above the par value of the debt. The earlier in a bond’s life span that it is called, the higher its call value will be.

Callable bonds thus compensate investors for that potentiality as they typically offer a more attractive interest rate or coupon rate due to their callable nature. Despite the higher cost to issuers and increased risk to investors, these bonds can be very attractive to either party. Investors like them because they give a higher-than-normal rate of return, at least until the bonds are called away. Conversely, callable bonds are attractive to issuers because they allow them to reduce interest costs at a future date if rates decrease. Moreover, they serve a valuable purpose in financial markets by creating opportunities for companies and individuals to act upon their interest-rate expectations. Investors who depend on bonds for fixed income face what’s known as call risk with callable bonds compared to non-callable bonds.

The conversion from the bond to stock can be done at certain times during the bond’s life and is usually at the discretion of the bondholder. Raising capital through issuing convertible bonds rather than equity allows the issuer to delay dilution to its equity holders. In this case, it can force conversion at the higher share price, assuming the stock has indeed risen past that level. A callable bond, also known as a redeemable bond, is a bond that the issuer may redeem before it reaches the stated maturity date. A callable bond allows the issuing company to pay off their debt early. A business may choose to call their bond if market interest rates move lower, which will allow them to re-borrow at a more beneficial rate.

Aside from a lower interest rate, you may also have to purchase the new bonds at a higher price. Because of this, callable bonds are not ideal for investors who are looking for stable and predictable returns. However, the issuer should adhere to a specific schedule when redeeming part or all of its debt. On the dates specified on the bond offer, an issuer will call a portion of the bonds. The beauty of sinking funds is that it allows companies to save money in the process while staying away from the lump-sum payment, which may dent the company’s liquidity. Callable bonds are less likely to be redeemed when interest rates rise because the issuing corporation or government would need to refinance debt at a higher rate.

While there is a windfall profit for the bondholder in either case, the profit potential with a convertible bond is much higher. The prospectus of a callable bond specifies how much the issuer must pay over the original issue price when calling the bonds. The profit potential of a convertible bond, however, is unlimited.

The issuing company pays interest on the bond, which is called the coupon rate. If a convertible bond with a par value of $1,000 has a 6% coupon, it pays 6% annually ($60) or 3% ($30) semi-annually. Though the issuer can get windfall profits from both bond types, profit from convertible bonds is higher.

These are also convertible bonds, but they are characterized by some special features. First of all, they convert automatically when a certain pre-specified condition occurs. What is more, they convert when the share price is decreasing, and not increasing.

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