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Callable bonds give issuers the option to redeem the bond before it matures. They’re also referred to as redeemable bonds. Bond investors lend their money to entities or issuers for a certain period of time and in return investors receive interest on the principal. These entities typically return the borrowed principle to the bond investors by the bond’s maturity date.

An exception to this process of bond investing is using callable bonds, which allows the issuer to pay off its loans early by buying back its bonds before they reach their date of maturity. You can define a callable bond as one with a built-in call option.

Table of Contents

What Is a Callable Bond?

Callable bonds, also referred to as redeemable bonds, allow the issuer the right, but not the obligation, to redeem the bond before it reaches its maturity date. The entity that issues callable bonds has the right to prepay, or in other words, the bond is callable before its maturity date.

Issuers may use callable bonds when they expect interest rates to fall. That way, they can redeem their bonds and issue new ones at a lower coupon rate, reducing their overall interest expenses.
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How Do Callable Bonds Work?

When the issuer calls the bond, it pays investors the call price or the face value of the bond, along with the accrued interest to date. After that, the issuer no longer has to make payments on the bond.

Businesses may prefer callable bonds, since they have built-in flexibility that could lower costs in the future. For example, if market rates are 5% when a company first issues its bonds but they drop to 2.5%, a bond issuer paying 5% would call their bonds and get new ones at 2.5%.

Some bonds have call protection which forbids the issuer to buy it back for a certain period of time. During this period, the company can not call their bonds. However, at the end of this period, the issuer can redeem the bond at its specified call date.

Callable bond prices correlate to interest rates, since falling interest rates make callable bonds less valuable.

Finding the Value of Callable Bonds

The main difference between a non-callable bond and a callable bond is that a callable bond has the call option feature. This feature impacts the calculation of the value of the bond. To find the value of callable bonds, take the bond’s coupon rate and add 1 to it.

For example, a callable bond with a 7% coupon would be 1.07. Next, raise 1.07 to the number of years until the bond is callable. If the bond is callable in two years, you would raise 1.07 to the power of two, which would be 1.1449. Then, multiply that number by the bond’s par value or face value.

If the bond’s par value is $10,000, you would multiply $10,000 by 1.1449 to get 11,449, which is the value of the callable bond.

Recommended: How to Buy Bonds: A Guide for Beginners

Types of Callable Bonds

Bonds have different types of issuers. Municipalities and corporations both may issue callable bonds. Here’s a look at three common types of callable bonds.

1. Optional Redemption Callable Bonds

Some municipal bonds have a redeemable option 10 years after the issue of the bond was issued. However, bonds with higher yields might have a protection or waiting period according to the bond’s maturity date. For example, a five-year bond might not be able to be recalled until two years after it is issued.

2. Sinking Fund Redemption Callable Bonds

This requires the issuer to recall a certain amount or all of the bonds according to a fixed schedule. A sinking fund is money that a company reserves on the side to pay off a bond.

3. Extraordinary Redemption Callable Bonds

Extraordinary redemption is when the issuer recalls the bond before maturity if certain specified events in the bond contract occur such as a business scenario that impacts bond revenue.

Callable Bond Example

A callable bond with a par value of $1,000 and a 5% coupon rate issued on January 1, 2022 has a maturity date of January 1, 2030. The annual interest payments investors would receive is $50. This bond has a protection feature which doesn’t allow the issuer to recall the bond until January 1, 2026, but after that date, the bond can be redeemed.

The issuer believes interest rates will decrease within the next four years and decides to recall the bond on January 1, 2026. If the investor bought the callable bond through their broker at its $1,000 par value, and the issuer chooses to redeem it when the protection period expires in 2026, they would calculate the value of the callable bond as follows:

•   Take the coupon rate and add 1 to it, to make 1.05.

•   Next, multiply 1.05 to the fourth power since the issuer will hold on to it for four years.

•   This calculation will yield 1.2155.

•   Next, multiply 1.255 by the bond’s par value of $1,000 to get $1,215, the value of the callable bond.

Interest and Callable Bonds

From the perspective of the callable bond issuer, falling interest rates are an opportunity to recall your bonds and lower your interest rate. While the investor is compensated at the outset with a higher yield or coupon rate for investing in callable bonds, they must be aware of the added risks associated with this investment.

If interest rates stay the same or increase, there’s a lower chance the issuer will recall its bonds. But if investors believe interest rates will drop prior to the bond’s maturity date, they should be compensated for this additional risk. The investor must determine if the higher yield from callable bonds is worth the risk of investment because the call feature is an advantage to the issuer, not the investor.
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Pros and Cons of Callable Bonds

Like any other investment, callable bonds have benefits and risks. It’s important to keep in mind the pros and cons of investing in callable bonds when considering a long-term investing strategy.

Callable bonds are financial instruments that may carry more risk for investors than noncallable bonds (bonds only paid out at maturity) because there is the chance of the bond being called prior to it reaching maturity.

Pros Cons
Companies issue callable bonds at higher interest rates to compensate for the risk of early redemption. This means the possibility of greater investment returns. If an issuer calls its bonds early as a result of lower interest rates, bond investors risk not being able to find bonds with lower coupon rates. This could pose a challenge for income-seeking investors who want a reliable stream of passive income from bond investing.
One of the benefits of callable bonds is the option to call the bond early. Instead of waiting until the bond reaches maturity, the issuer can recall the bond earlier to suit their financial business needs. Callable bond investors who pay a premium, or more than a bond’s face value risk only getting back the face value of the bond. This means the investor would lose their money on the premium they already paid.
Callable bonds have benefits that mostly favor the issuer. When interest rates fall, the company can redeem the bonds early and issue new bonds at a lower rate to save on interest payments. Another risk is the bond’s maturity. The longer it takes for the bond to mature, the greater the likelihood for the bond to be called early, especially if there is a change in interest rates. Investing in bonds with a shorter maturity date carries lower interest rate risk.

The Takeaway

Again, callable bonds give issuers the option to redeem the bond before it matures. They’re also referred to as redeemable bonds. Callable bond investors lend their money to entities or issuers for a certain period of time and in return investors receive interest on the principal.

Some investors might consider buying callable bonds as one way to diversify an investment portfolio or to achieve higher yield, however, it’s important for investors to keep the risks associated with this investment top of mind. In an environment where interest rates are falling, callable bonds may not work for long-term investors looking for income.

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FAQ

Are callable bonds a good investment?

Callable bonds may be a good investment depending on an investor’s strategy, risk tolerance, and time horizon, but the overriding interest rate environment may also determine how good of an investment they are as well.

What does it mean if a bond is callable?

If a bond is callable, it means that bonds can be redeemed or paid off by their issuer before they reach their maturity date.

What is the call rule on a callable bond?

The call rule on callable bonds refers to the ability of a bond to be redeemed or repaid by its issuer prior to its maturity date.

What happens to callable bonds when interest rates rise?

When interest rates rise, callable bonds are less likely to be called, though there are no guarantees.

Are callable bonds cheaper?

Generally, callable bonds tend to be less expensive than normal bonds because of the call option, which are of value to their issuer, and may lead to a relative discount for the buyer.

Do callable bonds have higher yields?

Callable bonds do tend to have higher yields, but often not greatly so, and there’s no guarantee that the yields would be higher than those of other types of bonds.

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I don’t usually dive into odd niche topics like this, but I just spent 12 hours car shopping over the weekend. That’s a lot of test drives and awkward conversations with over-enthusiastic salespeople. Sorry, Clayton, I can’t picture myself driving this car off the lot today…why do you ask?

Long story short, I’ve compared tons of cars recently. Hybrids, as you might know, are always more expensive than their all-gas counterparts. But…aren’t hybrids cheaper to operate? Which means…could they save us money in the long run?! This got my finance brain whirring to life.

I wrote an article in 2020 and updated it in 2023 that covers the real, total cost of car ownership. The cost of car ownership can be broken down into 6 main categories:

  • Purchase/Depreciation
  • Financing
  • Maintenance and Repair
  • Fuel
  • Registration/Inspection
  • Insurance

Financing rates, registration costs, and inspection costs are universal for all cars. There’s no difference between a traditional gas car and a hybrid on those axes.

But we know (or at least suspect) purchase costs, maintenance, fuel, and insurance costs will vary between hybrids and all-gas cars.

A Bird in the Hand…

Aesop wrote in 600 BC that “a bird in the hand is worth two in the bush.” Or, in modern terms, “I’d rather have a dollar in my hand today than two dollars in 20 years.”

Money today is worth more than money in the future. This is called discounting. And we’ve used this idea before to analyze mortgage costs.

We’re faced with a similar problem today.

When we buy a hybrid car, we spend more on the purchase price today. But, ostensibly, we save operating costs each year we own the vehicle. However, those future savings are worth less than the extra dollars spent today.

Do we save enough on long-term operating costs to compensate for the differences in sticker price and depreciation? That’s the question!

To answer it, we need to:

  1. Understand the differences in costs between gas cars and hybrids (sticker cost, depreciation, fuel costs, insurance costs, maintenance costs).
  2. Determine an appropriate discount rate for this analysis and apply it.

An Appropriate Discount Rate

As of 2022, the average age of all cars on American roads is 12.5 years. That said, the average car owner has their vehicle for 8 years before (most often) selling it or (less often) it breaks down completely.

Therefore, a happy medium duration for today’s analysis is 10 years. We’re going to look at the differences between hybrids and gas cars over a 10-year life.

How much less valuable is a dollar in 2034 than a dollar today?

Warren Buffett uses U.S. Treasury bond rates as his discount rate. I’m inclined to agree with him. It’s “the risk-free rate.” In any analysis, we can ask ourselves, “Would I rather pursue [this risky option], or simply invest my money in U.S. Treasury bonds for a decade or two?” Good enough for Warren, good enough for me.

As of February 2024, the 10-year Treasury rate is 4.3%. The table below shows how to apply that discount rate to future savings.

Example: I could take $74.47 today, invest it in a 4.3% annual interest bond, and I’d have $100.00 in seven years. Thus, if a hybrid car saves me $100 in 2031, it’s precisely the same as having $74.47 in my pocket today in 2024. A bird in the hand…

How Much Does a Hybrid Save Us?

We need an example of two cars to analyze. Since Kelly and I are currently active car market participants (we’re soon to have a “Baby on Board”…by the way, what’s the deal with those stickers?), I’ve been researching the Kia Sorento. Let’s dig into the details of the all-gas Sorento vs. the hybrid Sorento.

All these details I’m about to share with you are shown mathematically in this spreadsheet. Please feel free to make a copy and play around yourself.

To make a copy of a Google Sheet: File –> Make a Copy

Sticker Price and Depreciation Rate

The gas Sorento starts at $31,990. The hybrid Sorento starts at $36,990.

According to iSeeCars, both vehicles will depreciate 53% in their first 5 years.

Gas Expenses

To calculate estimated gas expenses, we need to understand:

  • how far we drive
  • our miles-per-gallon efficiency of the cars
  • and the cost of gas

Depending on your source, the average American drives between 13,000 and 15,000 miles per year. We’ll use 14,000 miles per year for this article.

The Kia Sorento hybrid gets 35 miles per gallon (we’re looking at the all-wheel drive model, thanks to snowy Rochester winters). The all-gas Sorento gets 24 miles per gallon.

Average American gas prices are currently $3.27 per gallon.

We combine those numbers to find out:

  • The Sorento Hybrid incurs $1308 of gas expenses per year.
  • The all-gas Sorento incurs $1907 of gas expenses per year

Insurance Costs

The average “full coverage” auto policy costs $2000. Your miles may vary (#carjoke).

Insurance is very personal in that nature. Your driving history and desired coverage level significantly affect the insurance premium.

Nevertheless, we’ll use $2000 per year for the all-gas Sorento. Hybrid insurance costs, on average, 7% more than all-gas models; the Sorento Hybrid will cost $2140 per year.

Maintenance

Most sources cite that hybrid maintenance costs are lower than all-gas engines, as hybrids use regenerative braking (fewer brake replacements), don’t use alternators or starters, and tend to have simpler transmissions.

Unfortunately, I cannot find any sources that provide hard numbers to support this claim! If you find something, please let me know.

Therefore, I’m using an average figure of $600 per year for repairs and maintenance and biasing those dollars towards the end of the cars’ lives. Newer cars break down less and are covered by various levels of warranty.

Is it just me, or is that grease very intentional?!

All-In Costs: Hybrid vs. All Gas

Over our 10-year analysis period, the Kia Sorento Hybrid would cost us $55,662 (depreciation + gas + insurance + maintenance), as measured in 2024 dollars.

The all-gas model would cost us $56,491.

Pretty darn close, but it’s a slight nod to the hybrid model. Category-by-category, the results are:

  • The hybrid costs $3000 more in depreciation costs.
  • The hybrid saves $4997 in gasoline costs.
  • The hybrid costs $1167 more in insurance.

And while I’m focusing only on dollars and cents here, there’s an environmental argument too. I won’t dive into the details. But you should probably place a value on environmental costs and benefits (albeit a difficult value to define in dollars and cents).

Of course, this is a perfect example of “average pilot syndrome.” Averages are useful in theory but rarely in practice. You must re-run this analysis for your unique scenario. The first questions that come to mind are:

  • Which specific model are you looking into? It might not be the Kia Sorento.
  • What are the miles per gallon ratios of the all-gas and hybrid models?
  • What are insurance rates like? Not only for your preferred car, but for you?
  • What are the typical maintenance costs of your desired car?
  • How does your car depreciate over time?
  • Should you adjust the discount rate? (PS – you can play around with the spreadsheet yourself, and you’ll see that the discount rate does not change the outcome significantly in this case.)

Was It Worth It?

We’ve covered a lot of conjecture and “what if” questions, made some assumptions, and created a spreadsheet. Is it all worth it?

First, I think I’m directionally accurate. Will the real world play out as I’ve modeled here? Of course not. For all I know, an asteroid will blast our car into smithereens on its first night in the garage (it’ll be a new kind of hybrid; half shrapnel, half vapor). But I think I have a better factual understanding now than I did before. I hope you agree.

This was ~2 hours of work (mainly on the writing, not the math) to optimize an $800 decision. And because I’ve discounted those future dollars, that’s $800 as measured today. Not bad! For some hybrids, this is likely to be a multi-thousand dollar difference. Nice!

Time to unplug, fill up, and peel out.

Thank you for reading! If you enjoyed this article, join 7500+ subscribers who read my 2-minute weekly email, where I send you links to the smartest financial content I find online every week.

-Jesse

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Getting money to start in real estate investing is the biggest hurdle for people. Traditional lenders have stringent requirements, making it hard for people just getting started and hard for people looking to take their real estate investing to the next level.

This is where private money, an alternative to traditional financing, comes in. In this article, I’ll cover what you need to know.

Private money has been a key piece of my strategy. I would not have built my real estate business without it.

Table of Contents

Understanding Private Money

Private money refers to loans sourced from individuals or non-traditional institutions rather than conventional banks. These people invest their own capital directly in your project, secured by the property itself.

Said another way, private money usually means borrowing from a person who is looking to earn interest on their cash. For taking a risk on you and your project, they get some form of recourse, which may include getting the title to your property if you don’t pay the loan back according to the terms of the agreement.

Here’s what real estate investors get with private money:

  • Faster closing times: No red tape, which expedites deal execution.
  • Flexible criteria: Less rigid evaluation and underwriting, catering to scenarios banks might reject.
  • Custom terms: Negotiate interest rates, loan amounts, and repayment structures directly.

Private money loans are different than hard money loans. You can read about Hard Money here.

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Key Points to Remember

  • Higher interest rates: Compared to traditional loans, expect rates ranging from 8% to 15% or higher.
  • Shorter loan terms: Private money is typically short-term financing, lasting 6-24 months.
  • Due diligence is crucial: Verify the lender’s credentials, experience, and track record thoroughly.
  • Legal agreements are everything: It’s best to have a lawyer draft a comprehensive loan agreement outlining terms, rights, and responsibilities. If there is a dispute, it’ll come down to the terms of the agreement. A lot can be on the line in these deals, so ensure you understand the agreement in full.

Just starting out? See my post The Best Way To Invest In Real Estate.

Pros of Private Money

Private money is one of the best options to start your real estate investing and to scale it.

It can also help kickstart the BRRRR method to rapidly expand your real estate holding. Here’s my article on How to Use the BRRRR Method, including using private money.

  • Access to capital: Secure funding even with imperfect credit or unconventional projects.
  • Speed and agility: Move quickly on time-sensitive deals and capitalize on fleeting opportunities.
  • Direct relationship: Build rapport with the lender, potentially fostering future collaborations.

Cons of Private Money

  • High costs: Interest rates and origination fees can significantly impact your profit margins.
  • Short timelines: Pressure to exit the investment quickly for repayment can limit options.
  • Risk of default: Non-compliance with loan terms could lead to property foreclosure.

Additional Tips

  • Start small with your first private money loan to build trust and experience.
  • Network with real estate professionals and advisors for recommendations on reputable lenders.
  • Have a solid business plan and financial projections to demonstrate your investment’s viability.

How to Find Private Money

Private money can be a great option for real estate investors. And it’s been a great way for me to scale my real estate.

If you want to find private money, you can read my article How To Find Private Money For Real Estate Investments.

Conclusion

Private money can be an incredible way to get started and also scale up. It’s been critical in my journey.

However, know what you’re getting into. Carefully understand the terms, exit strategy, and your risk tolerance.

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Source: investfourmore.com