Definition
Callable bonds give issuers the right (but not obligation) to repay the bond early, typically when interest rates fall so they can refinance at lower rates. Investors demand higher yields on callable bonds to compensate for call risk. When rates fall, callable bond prices are capped near the call price—known as price compression or negative convexity.
lightbulb Example
A 10-year callable bond has a 5% coupon and is callable after 5 years at $1,020. If rates drop to 3%, the issuer will likely call the bond, forcing investors to reinvest at lower rates.
verified_user Key Points
- Issuer benefits from falling rates
- Investors receive higher yield as compensation
- Price capped near call price (negative convexity)
- Yield-to-worst considers all possible call dates