How Does Calling a Bond Work?
For negative arbitrage, consider a municipality that issues bonds with a 4% interest rate.
The proceeds from the bond issuance are then invested in securities that yield only 2%. In this case, the municipality is paying 4% on the debt but only earning 2% on the investment, resulting in a 2% negative arbitrage. This means the municipality is losing money on the spread, which can be a financial burden if the discrepancy continues over time.
Negative arbitrage is generally undesirable because it represents a financial inefficiency.
However, it can sometimes occur intentionally in specific financing structures, such as in advance refunding transactions where bonds are issued to pay off old debt, and the funds are temporarily invested at lower returns until the call date.
Why Do Issuers Call Bonds?
Issuers generally choose to call bonds when market conditions change in their favor.
Here are a few common reasons for calling a bond:
- Declining Interest Rates: If interest rates fall after the bond is issued, the issuer may call the bond and reissue it at a lower rate, thereby saving on interest expenses.
- Refinancing Opportunities: Issuers may also call a bond to restructure their debt in a way that improves their financial flexibility or optimizes their debt portfolio.
- Excess Cash: If an issuer has surplus funds, they might decide to pay off debt early as part of a broader financial strategy to reduce liabilities.
What are the Risks for Bondholders?
While callable bonds offer a higher yield compared to non-callable bonds to compensate for the added risk, bondholders face the possibility of the bond being redeemed earlier than anticipated. When a bond is called, the bondholder loses the future interest payments, and they may have to reinvest the principal at a lower rate if interest rates have fallen.
This "call risk" can be particularly problematic for investors who depend on predictable, long-term income from their bonds.
As a result, callable bonds tend to have a higher yield to make them more attractive to investors willing to take on this risk.
What's Important Here?
Calling a bond means that the issuer repays the bondholder before the bond’s maturity date, typically to take advantage of favorable market conditions.
While this can be beneficial for issuers who want to reduce debt costs, it introduces call risk for bondholders, who may face reinvestment challenges if the bond is redeemed early.
