A call option grants the issuer the right (but not the obligation) to carry out an action. If the right is not exercised, the option lapses. Call options can be thought of as a “right to buy” — that is, for the case of a standard vanilla callable bond, the issuer has the “right to buy” the bond back from the investor at a predetermined price. The investor has no right to counteract the call when exercised and would no longer own the callable bond after it is redeemed.
Based on our tabulation using Bloomberg data, there are US$654.9 billion ($900.2 billion) of outstanding US dollar-denominated callable bonds in the Asia Pacific region, making up 37% of the total outstanding bonds (excluding perpetual issuances which are issues with no legal maturity date).
In the Singapore dollar credit market, there are $19.0 billion of outstanding callable bonds, making up 25% of the total outstanding bonds using the same basis. These callable bonds are mainly Tier 2 bank capital instruments. If we also include perpetual issuances (e.g. Additional Tier 1 bank capital instruments, non-financial corporate perpetuals) which are a common feature in the Singapore dollar credit market, the outstanding papers with call option total $44.0 billion.
Outside of bank capital issuances and non-financial corporate perpetuals, there are only four notable senior unsecured callable bonds issued in the Singapore dollar credit market totalling $2 billion.
Key types of call options
There are three main types of call options. First, standard calls, which give the right to the issuer to redeem a bond earlier than maturity date at specified dates, which is usually at par in the Singapore dollar credit market. Second, makewhole calls, which are usually not tied to specific dates but when exercised, they compensate investors based on forgone future payments, which can work out to be at a premium. Third, event-driven calls, which are linked to a corporate action, such as a change of control in a merger and acquisition. The new controlling shareholder may exercise the call should there be cost savings to the issuer in doing so.
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What makes a callable bond?
A callable bond typically refers to bonds with a fixed maturity date embedded with a standard or make-whole call option. As such, bonds with calls linked to corporate actions only may not necessarily be termed as a callable bond, unless they have a fixed maturity date and are embedded with a standard or make-whole call. Non-callable bonds can still have other kinds of optionality features baked into the terms and conditions, such as the option for the issuer to redeem upon change of control, option to convert (e.g. to equity). A callable bond may have multiple embedded options, though standard callable bonds tend to only have one embedded call option.
Why would an issuer call?
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Risk-neutral issuers who make decisions based on economic considerations rather than emotional tolerance of risk would typically exercise the call option if it is cheaper to replace the bond. Replacement funding can become cheaper when an issuer’s creditworthiness improves. As such, call options are more valuable for high-yield issuers whose credit profiles are improving. Replacement funding can also become cheaper when interest rates fall and/ or when credit spreads fall.
However, in the case of financial institutions, capital instruments (e.g. Additional Tier 1, Tier 2s) have tended to be called, even if the cost of replacement is higher. One possibility is that not calling may signal credit stress. Financial institutions operate on a confidence-sensitive leveraged business model, (although they are also highly regulated) and the ability to continue with this business model relies on maintaining a good credit reputation among depositors, customers and investors.
As an example, Credit Suisse Group continued to pay the distributions on its Additional Tier 1 instruments prior to their write-down even though it may have been prudent not to as losses accelerated. The Swiss National Bank, in its 2023 Financial Stability Report, highlighted that this was likely due to the anticipated negative market reaction that may have accelerated the decline in confidence or increased the difficulty for Credit Suisse Group’s refinancing activities.
Issuers may also exercise the call when capital is no longer required. Genting Singapore G13 exercised the call of its perpetuals as the issuer was generating healthy cash flows and had minimal operational need for excess cash.
Why would investors buy a callable bond?
The yield on the callable bond is typically higher than a bond without a call option. This can allow investors to generate excess returns versus holding non-callable vanilla bonds (may also be referred to as the “option-free” bond), though this subjects investors to reinvestment risks as future coupon payments or distributions would be forgone when a callable bond gets called. Reinvestment risk increases when a call happens amidst a lower return environment.
To provide some protection to investors against reinvestment risk, callable bonds typically come with a protection period for investors where issuers are not allowed to call on the bond, known as “non-call” period or “NC”.
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For example, a 10NC5 bond is a bond that matures in 10 years; however, the issuer is only allowed to start calling the bond at the end of the fifth year. This means that when an investor buys a callable bond, the investor knows that for the first five years at least, the investor will be getting paid the contractual interest. When the probability of a call is certain, investors of standard callable bonds would be well served to consider the yield-to-call rather than the maturity date, in assessing their expected returns.
Conversely, in a rising interest rate environment, the probability of the call getting exercised falls. Assuming the callable bond is not called and reaches maturity, the callable bond will pay out the higher return overall versus the non-callable vanilla bond with the same maturity date. In some cases, a callable bond may be preferred when interest rates are rising quickly as proceeds could be reinvested at higher rates.
However, the investor does not get to determine whether the callable bonds get called. For issuers to still choose to call a callable bond, this would generally require some other feature such as step-up margins or resets that increases the cost of not calling. Holding all else constant, these features also benefit the investors; in the event the bond is not called, at least the coupon rates go up when rates are rising.
Valuation of the call option
In determining the “fair value” of callable bonds, they are generally compared against similar but non-callable “option-free” bonds with otherwise same features and creditworthiness. The price of a callable bond should then be lower than the “option-free” bond (which implies that the yield of a callable bond should be higher), with the difference in price being the value of the option.
If the issuer does not exercise the call option, similar to an “option-free” fixed maturity bond, the issuer would need to pay all the contracted interest payments. This means if there is no default and the investor holds the bond to maturity, the investor will get back all the promised cash flows on their initial investment.
If the issuer exercises the call option, the investor will not be paid the cash flows after the redemption of the bond. As such, callable bonds have capped prices. To illustrate, “option free” bond prices rise when interest rates fall, and the rise in prices is uncapped. In contrast, when interest rates fall, issuers have increased incentives to exercise the call and refinance cheaper. This limits gains to the predetermined call price (the price at which issuers will pay investors, and this may only be at par).
The derivation of the value of the option is complex and the complexity increases when there are multiple embedded options. The value of call options is affected by time to maturity, volatility of interest rates and the interest rate trajectory, among other factors.
Even when it does not make economic sense to act on the call option at a point in time, an issuer may find the option valuable when circumstances change subsequently or where callable bonds are likely to be an enduring or necessary feature in an issuer’s capital structure. The passage of time and higher volatility mean a higher probability for circumstances to change and more time for issuers to decide. When the callable bond reaches closer to maturity, the value of the call option declines, and the callable bond price will become very close to the non-callable “option-free” bond.
How interest rates move going forward is also important. A persistent inverted yield curve suggests that interest rates may fall in the future. Holding all else constant, the call value is higher to the issuer in an inverted yield environment. The more flexible the call, the higher the option value to the issuer. For example, an American call that can be exercised at any date prior to expiration will have a higher value versus a Bermudan call with a schedule of fixed exercise call dates. The Bermudan call-in turn is more flexible versus a European call with one fixed exercise date upon expiration.
Ezien Hoo, Wong Hong Wei, Andrew Wong and Chin Meng Tee are credit research analysts with OCBC’s Global Markets Research & Strategy team
