When a company issues bonds to raise capital, it often chooses "callable" bonds. A callable bond is a one that the company can redeem for its holders prematurely, before the bond has reached its preset maturity date. Although callable bonds are slightly more expensive than normal bonds to issue, they have a number of advantages for the company.
The biggest advantage to the company issuing a callable bond is flexibility. Because the bond allows the company to call it in before the date on which it would mature, the company has the option of paying out early. This means that the company does not need to keep paying back investors for as long as it had planned to. This is a good option if the company finds itself with extra cash.
One of main downsides to issuing normal, non-callable bonds is that the company must pay out a set amount of interest to bondholders over a set period. This interest is a cost of borrowing. However, with callable bonds, if the company finds that it can afford to pay off the bond prematurely, it can reduce its interest payments by paying the outstanding debt back all at once.
Taking Advantage of Lower Interest Rates
Callable bonds also provide an excellent advantage to the company in case interest rates drop unexpectedly. If the interest rate drops before the bond has been fully paid out, the company can call it back and issue a new set of bonds, or take out a new set of loans at lower interest, saving a significant amount.
Although callable bonds give company more flexibility, they are slightly more expensive for the company than are normal bonds. Investors are slightly more wary of buying a bond that could be called back at any moment, so means companies must pay investors something extra to induce them to buy this type of bond. This higher rate of interest is an advantage for investors.
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