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Definition: Call Privilege
This refers to a provision in a bond issue that gives the bond issuer the flexibility to redeem all or part of the bond issue at pre-determined prices on certain specified dates. The call privilege safeguards the issuer from lower interest rates. But the buyers of the callable bonds deal with reinvestment risk, i.e. they have to reinvest the bond proceeds at a lower prevailing interest rate. The pre-determined call price is generally higher than the par or issue price which is demanded by the investors who take the risk. Also, the issuer generally pays a higher coupon rate for a callable bond as compared to other bonds of comparable maturity and credit quality.
To invest in Bonds with Call Privilege or simply callable bonds, investors should look at Yield to call (YTC) rather than yield to maturity (YTM) to take a more informed investment decision.
Let’s see how to calculate YTM and YTC. Assuming we have a bond with following attributes:
2 year bond, callable after 1 year, call price = $100, face value = $100, currently selling at $99, semiannual coupon rate 8%.
• At time 0.5: $4
• At time 1.0: $4
• At time 1.5: $4
• At time 2.0: $104
YTM= y = 8.55%
Assuming bond called after one year
• At time 0.5: $4
• At time 1.0: $4 + $100 = $104
YTC = y = 9.07%
Callable bonds are liked by the borrowers and disliked by the lenders. Though call price is higher than the par or issue price to compensate for the risk taken by the lenders, issuers also introduce a call protection period, during which the callable bond cannot be called.
Example: Callable bond structure 10 NC 5: This means that bond has 10 years till maturity and can be called only after 5 years.