Legal Definitions - callable security

A callable security is an investment instrument, such as a bond or preferred stock, that grants the issuer (the entity that originally sold the security) the right to repurchase it from the investor before its scheduled maturity date or redemption date. This feature allows the issuer to retire the security early, often to take advantage of more favorable market conditions, such as lower interest rates, or to restructure its finances.

Here are some examples to illustrate this concept:

• Corporate Callable Bond: Imagine a large technology company issues bonds with a 5% interest rate, maturing in 20 years. These bonds are designated as callable after five years. If, ten years later, market interest rates have dropped significantly to 2%, the company might decide to "call" these 5% bonds. This means they repurchase the bonds from investors at a predetermined price (often face value plus a premium) and then issue new bonds at the current lower 2% interest rate. This action allows the company to reduce its borrowing costs substantially over the remaining life of the original bonds.

  This illustrates a callable security because the company, as the issuer, exercises its right to buy back the bonds before their 20-year maturity, driven by the financial advantage of refinancing at a lower rate.

• Municipal Callable Bond: A city government issues bonds to fund a new public transportation project. These bonds pay a 4% interest rate and are callable after seven years. Several years later, the city experiences unexpected economic growth, leading to a much stronger credit rating. This improved credit rating allows the city to borrow money at a lower interest rate, say 3%. The city council decides to call the existing 4% bonds, paying back the investors, and then issues new bonds at the lower 3% rate. This saves taxpayer money on interest payments for the remainder of the bond's original term.

  Here, the municipal government, as the issuer, uses the callable feature to refinance its debt at a more favorable rate due to improved creditworthiness, demonstrating its right to redeem the security early.

• Callable Preferred Stock: A utility company issues preferred stock that pays a fixed dividend of $2 per share annually. This preferred stock is callable by the company at $50 per share after three years. If the company later finds itself with excess cash flow and wishes to reduce its ongoing dividend obligations, or if it wants to simplify its capital structure, it might decide to call the preferred stock. It would repurchase the shares from investors at the $50 call price, thereby eliminating the future dividend payments associated with those shares.

  This example shows that callable features are not exclusive to bonds. The utility company, as the issuer, exercises its option to buy back the preferred stock, ending its obligation to pay future dividends, which is a key characteristic of a callable security.