A bond is callable when the issuer has the right to return the investor's principal and cease all interest payments before the bond matures. For example, a bond that matures in 2030 might become callable in 2020.
Issuers must clearly specify whether their bonds are callable, and the precise terms of the call option, when the bonds are first offered for sale.
Typically, a bond that is callable will become callable at a premium. For example, it might become callable at a price of 102, or $1020 per $1000 of face value, meaning that the issuer has to give investors that amount in order to call the bond. After a year, the call price might decline to 101. After another year, it might decline to 100, or par, and remain callable at par for the remainder of its life.
Issuers call bonds when interest rates drop below where they were when the bond was issued. For example, if a bond is issued at a rate of 7% and the market rate for bonds of that type drops to 6% and stays there, when the bond becomes callable the issuer will likely call it in order to issue new bonds at 6%. Obviously, callability benefits issuers and hurts investors, who are faced with the prospect of reinvesting their money at lower interest rates.
Issuers entice investors to buy callable bonds by paying higher interest rates on callable bonds than on noncallable bonds. But the price of a callable bond will not rise much above its call price, no matter how low interest rates go, because dropping interest rates increase the likelihood that it will be called.
Most municipal bonds and some corporate bonds are callable. Treasury bonds and notes, with very few exceptions, are noncallable.