Call Privilege

"Membership has its privileges," American Express ads used to tell us. Certain bond issuers also have privileges...specifically, the privilege of calling in their bonds before the maturity date if interest rates in the market go down.

Known as callable bonds, the issuer will clearly state what the possible call dates will be and the amount of extra premium they will pay to make up for the lost interest the holder would have received if the bonds had gone to maturity. Callable bonds usually start out offering a higher interest rate than bonds of similar risk.

Example: The city of Flint, Michigan needs additional funds to continue replacing water pipes that became corroded with lead. So, they issue a $5,000 callable bond with a 6% coupon (interest payment) and a maturity date of January 1, 2028. However, there's a call date of September 30, 2022 with a call price of $5,060. Because this bond issue has a call date, the 6% interest is probably better than what is being offered by similar-risk bonds and maturity dates.

Suppose that in the summer of 2022 interest rates in the market tank, so the city of Flint decides to call in the 6% bonds and issue 4% bonds. They will pay their investors a premium of $60 as a call price per bond ($5,060 - $5,000) to help make up for missing out on the higher interest rate for four years. Flint wants to refinance their higher interest bonds for lower interest ones in order to incur less debt. Also, when interest rates go down, the price of a bond goes up, so the city can most likely issue new bonds at a lower interest rate and get a higher price.