Summary

Corporate and municipal bonds usually allow the issuer to call the bonds at a stated call price. This call feature permits the issuer to refund the issue at a later date after a decline in interest rates. A refunding allows the firm to replace a high-coupon debt with a lower-coupon debt, saving interest costs over the remaining life of the bond.

In an informationally efficient market in which the bondholders and the firm have the same information, the market sets the features (i.e., coupon, call price, and period of call protection) on a callable bond to make the marginal bondholder and issuing firm indifferent between callable and noncallable bonds. Similarly, the marginal market participant is indifferent between long-term callable bonds and short–term bonds. In imperfect markets, firms may have incentives to issue callable bonds.