What should I check before buying a callable bond?

Before buying a callable bond, identify when the issuer may redeem it, the price payable then, which interest is owed and how that ending compares with the price you pay. Examine the call scenario alongside maturity. A quoted coupon does not promise that every planned future coupon will arrive.

FINRA's callable-bond explanation describes the issuer's option to redeem before maturity and the resulting reinvestment risk. It also directs investors to the prospectus for call terms. Obtain the actual terms for the exact bond, not just a description of the issuer.

Write the two permitted cash schedules

Use a wholly fictional bond with $1,000 face value, an eight percent annual coupon and exactly three years remaining to maturity. Coupons are $80 annually. The investor pays a complete $1,100 immediately after the previous annual coupon, so no accrued interest is paid to the seller.

In this deliberately simple contract, the only early call opportunity is on the first annual coupon date, one year after purchase. If called, the issuer pays $1,000 plus that date's $80 coupon and the bond ends. If not called then, no later early redemption is permitted; it pays $80 at years one and two and $1,080 at year three.

There are no fees, income taxes, defaults, partial calls, other distributions or reinvestments in either supplied schedule. All promised payments are assumed to arrive in full and on time for these calculations. Those are scenario assumptions, not an assessment of a real issuer's credit.

Calculate the one-year call ending

If the issuer exercises the call, the investor receives $1,080 one year after paying $1,100. The cash loss is $20. Dividing negative $20 by $1,100 gives approximately negative 1.82 percent for that one year.

The eight percent coupon was paid in full. The loss comes from paying $100 above the $1,000 call principal while receiving only $80 interest before redemption. This is not a default or a failure to pay the coupon.

For this exact one-year, one-receipt schedule, that negative 1.82 percent is also the annual yield solving the cash equation: $1,100 × (1 + yield) = $1,080. A real yield-to-call calculation with different dates, accrued interest or multiple coupons needs those actual cash flows and quotation conventions.

The coupon-and-price guide explains why the coupon's face-value denominator differs from the price paid. Here the call adds another reason the buyer's result differs from the coupon: it changes which future cash flows remain.

Keep the no-call ending on its own dates

If the issuer does not call at year one, the supplied three-year receipts are $80, $80 and $1,080. Total nominal receipts are $1,240, which exceeds the $1,100 purchase by $140 over the whole three years.

That $140 divided by $1,100 is about 12.73 percent in aggregate. It is not an annual yield, and simply dividing it by three would ignore the earlier coupon dates. The dated-cash-flow guide explains why timing belongs in an investment comparison.

The two endings cannot be added together. Once the bond is redeemed, the later coupons in the no-call schedule no longer belong to it. Nor is the $160 of absent later coupons a complete measure of the economic disadvantage: in the call branch, principal also returns two years earlier and could be used differently.

Test the income plan after a call

If the investor needs $80 annually for the next two years, the call branch needs another plan. Its returned $1,000 principal is not an offer to earn eight percent again. Available reinvestment rates, credit quality, fees and maturities would need a fresh comparison.

The issuer has the stated option, not an obligation to exercise it. The investor cannot demand the call merely because an early return would now be convenient. Whether the issuer chooses to call has not been predicted in this example.

For a real bond, read all call opportunities and prices, notice provisions, any protection period and how the issuer selects a partial redemption. Ask which call date a quoted yield uses and whether other permitted endings could be less favorable. A single example cannot supply every instrument's worst case.

Keep credit, price and cash needs separate

A noncalled bond still carries issuer and market risks. A plan to hold does not establish that the issuer can pay, and a plan to sell before redemption needs a buyer and an actual price. Duration, discussed in the price-sensitivity guide, answers another question and can be affected by call features.

Before purchasing, record the complete price, each relevant contractual cash schedule and the date you need the money. Compare an appropriately calculated yield for those schedules rather than selecting the largest percentage on the screen.