What Is Noncallable?
Let me explain what a noncallable security is. It's a financial security that the issuer can't redeem early unless they pay a penalty. When you issue a noncallable bond, you're committing to that interest rate until it matures, which means you're taking on interest rate risk. If rates drop, you still have to pay the higher rate right up to maturity.
You'll find that most treasury securities and municipal bonds fall into this noncallable category.
Understanding Noncallables
Preferred shares and corporate bonds come with call provisions outlined in the prospectus or trust indenture at issuance. These provisions specify if a bond is callable or noncallable. A callable security lets the issuer redeem it early, paying a premium to the investor to cover the risk of losing out on future interest if it's called before maturity.
Bonds get called often when interest rates fall, because the issuer can refinance at a lower cost. For instance, if market rates drop to 3%, but your existing bond pays 4%, that's a higher borrowing cost for the issuer. They might redeem those bonds and issue new ones at the lower rate. This benefits the issuer but puts you, the bond investor, at reinvestment risk—meaning you might have to reinvest at that lower rate.
A bond can be noncallable for its entire life or just until a certain period after issuance. If it's fully noncallable, the issuer can't redeem it early no matter what happens to interest rates. As a bondholder, you're protected from losing income due to early redemption. You're guaranteed those regular coupon payments until maturity, making your interest income and return predictable.
Issuers, though, are stuck with higher interest payments if rates drop, leading to a higher cost of debt. That's why noncallable bonds usually pay lower interest rates than callable ones. The risk is lower for you as the investor, since you're assured of the stated rate for the full term.
Special Considerations
Some callable bonds start out noncallable for a set period after issuance—this is the call protection period. For example, a 20-year bond might not be callable until eight years after issue. This ensures you get interest payments for at least those eight years while it's noncallable.
Once the protection ends, it becomes callable, and the first possible redemption date is the first call date. If the issuer calls it early due to better rates, your interest payments stop. Redeeming a noncallable bond or preferred share before maturity or during protection requires a steep penalty.
Fast Fact
Remember, this information isn't tax, investment, or financial advice. It's presented without considering your specific objectives, risk tolerance, or circumstances, and it might not suit all investors. Investing carries risks, including potential loss of principal.
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