A callable security gives the issuer of the bond the right to redeem it at predetermined prices at a specified time prior to maturity. Yields on callable bonds tend to be higher than yields on noncallable bonds because the investor must be rewarded for taking the risk that the issuer will call the bond if interest rates decline, forcing the investor to reinvest the proceeds at the prevailing lower yields.
Example: ABC Company issues a 10-year, non-callable bond at 6.5%. XYZ issues a similar 10-year bond, but it is callable after 3 years. XYZ Company needs to pay investors an interest rate of 7% in order to compensate investors for the possibility that in year 4, XYZ Company calls the bonds in order to take advantage of prevailing interest rates of only 5%. XYZ company calls the bonds and is able to receive financing at a lower rate, but the bondholder who had a 7% investment must now reinvest in a market where he will likely receive a lower rate.
Prices on callable bonds depend on the market’s expectation of interest rates at the time the call feature on a bond becomes active. If the market expects that the interest rate environment at the time of the call provision will be such that the company will exercises its option to call the bond, the option is said to be “in the money” which can cause the security to trade at a price higher than a bond’s face value. Those securities priced below face value, with a coupon below the going market rate are discount callables. The market expects that given the prevailing interest rate environment, the company will not exercise its option to call the bonds.