A callable bond comprises what is called a call provision. This call provision is made known to prospective investors at the outset and gives the issuing entity the right to recall the bond and pay the holder a predetermined amount of money representative of, but usually less than, the remainder of all principal and interest payments. This is an instance in which the borrowing party makes the call on the bond out of concern that its financial position will not allow it to repay all interest and principal by the maturity date.
Callable loans function in a similar manner as callable bonds, with the exception that the lending party, as opposed to the borrowing party, bears the right to exercise the call provision. The presence of this provision is, again, clarified at the outset of the loan and may be exercised by the lender at will, provided that it is done within predetermined time constraints.
The applicable parties in callable debt arrangements normally exercise the call provision when it becomes questionable whether or not the borrowing party will have the solvency to repay the entirety of interest in principal within the time frame that remains until maturity. In the case of callable bonds, an issuer might exercise the provision following a decline in the prevailing level of interest rates, subsequently issuing new bonds at a lower, cheaper rate. Conversely, a rise in the prevailing level of interest rates might impel a lender to exercise the provision on a callable loan, and use the repaid funds to disburse a new loan at a higher interest rate.
The discretionary nature of the call provision is put in place to protect the lending party should it have reason to believe that it may not receive full repayment of interest and principal by maturity. For this reason, some are of the opinion that an ethical question exists as to whether or not the appropriate parties -- lender in the case of loans, issuers in the case of bonds -- are justified, should they exercise for reasons other than nonpayment risk. Others posit that since the call provision is understood by both parties from the start, the affected parties willingly assume this risk.
Other Types of Callable Items
In addition to loans and bonds, the call provision can also be applied to certificates of deposit as well as convertible bonds, whereby the call provision necessitates a compulsory conversion of the bond to shares of the issuer's stock at a predetermined price. Along the same lines, shares of both common and preferred stock may comprise a call provision, the exercise of which requires that holders redeem such shares in return for cash should the price reach a predetermined level in the market.