Firms that issue callable bonds have the option of repaying the principal to the bond buyers before the stated maturity date for the bonds. Firms may call their bonds before maturity in order to avoid making some of the coupon payments. Should we expect the price of a callable bond to be higher or lower than the price of a non-callable bond that has the same coupon payment, principal, and effective yield?

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The price of a callable bond should be lower than the price of a non-callable bond with the same coupon payment, principal, and effective yield because the call option held by the issuer reduces the value of the bond to the investor. With a callable bond, the investor is taking on the risk that they will not continue to receive coupon payments for the full duration of the bond if it is called early. Therefore, callable bonds typically have a higher yield than non-callable bonds to compensate investors for this risk.

Firms That Issue Callable Bonds Have the Option of Repaying