In volatile financial markets, when short-term financing is not available, call provisions can safeguard a company’s future stability. Despite sometimes high costs to underwriters and increased risk to investors, call provisions are very attractive to both parties. The eligibility of a company to buy back the bonds and refinance at lower interest rates when market rates fall is extremely beneficial for its financial future. However, bondholders have to forfeit their high-yield bonds for the call price, thereby giving up the prospect of an attractive coupon rate on their original investment. To compensate investors for this risk, callable bonds are issued with higher coupons and promised yields to maturity than regular bonds.
Financing flexibility can be achieved by including a call provision clause in the bond indenture. A call provision grants the underwriter the right to redeem the issued bonds, known as callable bonds, under specific conditions prior to the expiration date.
If a company is selling bonds and the future interest rates are anticipated to decline, a call provision in the bond contract is highly recommended. Provided the issue is callable, if interest rates drop, the company could sell a new issue of low-yielding securities. Then the proceeds of the new issue could be used to retire the high interest payments and thus reduce company’s interest expense. This process is called a refundable operation.
Generally, the call provision requires the underwriter to pay bondholders an amount greater than the par value. The compensation, known as call premium, equals the difference between the call price and the par value. The amount of the call premium may become smaller over time. Usually, the call premium equals a year’s interest if the bond is called within the first year, and the premium declines at a constant rate each year thereafter. For example, if you buy a 10-year callable bond with a $1,000 face value, and 10 percent coupon rate, the bondholder would be compensated $100 if the bond is called during the first year, $90 in the second year and by the maturity date the compensation would decline to 0. Assume that in three years the market rates have dropped to 5 percent. In this case, the underwriter would recall the bonds, because the company’s operating activities could be refinanced at a lower cost. At the refunding point the issuer pays off the investor the par value ($1,000), a 10 percent coupon ($100), and a call premium ($80).
Risk and uncertainty go hand-in-hand with the opportunity to make money. If interest rates in the economy have risen sharply, the company will not call the bond. As a result, the investor would be stuck with the original coupon rate on the asset, reflecting a significant principal value loses. However, if interest rates fall, the company will call the bond and pay off investors, who then must reinvest the proceeds at the current market interest rate, which is lower than the rate they were getting on the original bond. Considering the added risk, callable bonds carry higher interest rates to compensate bondholders. Call provisions are often not operative during the first part of the bond lifespan. The period of call protection is approximately 5 to 10 years, during which the company might be prohibited from calling its bonds. This is a deferred call provision.
Typically, a call provision is highly valuable to the issuing firms, but can be detrimental to investors. Callable bonds are attractive because they provide rewarding interest rates for risk-takers. For additional information on this and related topics, check out Jim Fink’s free report on Understanding the Stock Market: How to Buy Stocks and Other Stock Market Basics.