Callable stock definition
/What is Callable Stock?
Callable stock is a class of stock that gives the issuing company the right to repurchase the shares from shareholders at a predetermined price. The call feature is typically exercisable after a specified date and under defined conditions set out in the stock agreement. Companies use callable stock to regain control of ownership or reduce dividend obligations. The call price is often set above the original issue price to compensate investors. Because of the call risk, callable stock may offer higher dividends than comparable noncallable shares.
Advantages of Callable Stock
There are several advantages to offering callable stock to investors, though all of these advantages are from the perspective of the issuer, not the investor. The advantages are as follows:
Retain control. The issuer may only repurchase stock from minority shareholders, thereby allowing its majority shareholders to retain tighter control over the entity.
Avoid paying interest. If preferred stock is callable and that stock pays interest or a dividend, then repurchasing this stock will reduce the payout obligation of the issuer.
Cap the stock price. The market price of a share is usually capped at the repurchase price, since investors know that they will only be paid this amount in the event of a repurchase event.
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Disadvantages of Callable Stock
Callable stock has several disadvantages for investors, primarily due to the issuer’s right to repurchase the shares at a predetermined price, often at a time most favorable to the company. This means investors face the risk of losing potentially higher future returns if the stock is called away during periods of rising market value. It also creates uncertainty in investment planning, since shareholders cannot be sure how long they will hold the stock or continue receiving dividends. Additionally, callable features often lead to lower market prices or dividend yields, as investors demand compensation for taking on added risk. Overall, callable stock reduces investor control and can limit long-term growth opportunities.
Example of Callable Stock
ABC International issues preferred stock at $100 per share, with 8% interest. The stock agreement contains a call feature, under which ABC has the right, but not the obligation, to buy back the shares at any time after two years have passed, at a price of $120 plus any interest that has been accrued but not paid as of the buy back date.
A side effect of this example is that the market will not bid the price of the stock over $120, since a buyer could potentially lose the difference between $120 and any higher price paid to buy the stock if the company elects to trigger the buy back clause. Because of this built-in limitation on the price of preferred stock, investors tend to resist buying shares that contain the call feature. However, a company that is experiencing broad investor demand for its equity offerings may still be able to impose the feature.
The Right of First Refusal
A variation on the callable stock concept is the right of first refusal, under which a company has the right to meet any offer made to purchase the shares of a shareholder. By doing so, the business can reduce the number of shareholders, which concentrates voting rights with a smaller number of shareholders, and also reduces the risk that having an excessive number of shareholders will force the company to begin filing reports with the Securities and Exchange Commission as a public company.
Terms Similar to Callable Stock
Callable stock is also known as redeemable stock.