What call protection is
Call protection is something that can be part of a bond. A bond is when someone lends money to a company or government. The company or government agrees to pay back the money later, plus extra money called interest.
Sometimes the company or government that made the bond might want to pay back the money early. This is called “calling” the bond. But call protection stops them from calling the bond whenever they want.
Two types of call protection
There are two main kinds of call protection:
- Hard call protection
- Soft call protection
Hard call protection
Hard call protection means the company or government can’t call the bond at all for a certain amount of time. Even if they want to pay back the money early, they’re not allowed to. They have to wait until the time is up.
For example, let’s say a bond has 5 years of hard call protection. The company can’t call the bond for the first 5 years no matter what. They have to keep paying interest until the 5 years are over. Only then can they pay back the money early if they want to.
Hard call protection gives a lot of safety to the person who bought the bond (called the bondholder). They know they’ll keep getting interest payments for at least that period of time.
Soft call protection
Soft call protection is a bit different. With soft call protection, the company or government can call the bond early, but only if they pay extra money.
This extra money is called a “call premium”. It’s usually a percentage of the bond’s face value (the original amount of money borrowed). The bond agreement lists the specific premiums.
For instance, a bond might say:
- Before 2 years: Can’t be called
- Between 2-4 years: Can be called with a 5% premium
- Between 4-6 years: Can be called with a 3% premium
- After 6 years: Can be called with no premium
So in years 3 and 4, they could call the bond, but they’d have to pay 105% of the face value (the extra 5% is the premium). In years 5 and 6, calling it would cost 103%. After 6 years, they can call it for 100% (no premium).
The premiums get smaller over time. This gives some protection to bondholders, but not as much as hard call protection. The company has more flexibility to pay off the bond early if they want to.
Why call protection exists
Call protection exists because of something called interest rate risk.
Interest rate risk for bondholders
Imagine you buy a 30-year bond paying 5% interest per year. But after 5 years, interest rates have gone up to 7%. New bonds are paying more interest than yours.
You might wish you had bought a bond at the new, higher rate. Your old 5% bond is less appealing now. If you tried to sell it, you’d have to sell it for less money than you paid (called a “discount”).
This is interest rate risk. The risk that rates go up and your bond becomes less valuable. Call protection helps with this risk.
If interest rates rise, the company will probably “call” the bond. They’ll pay off the old bond and issue a new one at the new, lower interest rates. That’s great for them, but bad for the bondholders who were getting the higher interest rate.
Call protection prevents this, at least for a while. With hard call protection, you know you’ll keep getting that interest rate for a guaranteed period of time. Even with soft call protection, it would cost the company extra to call the bond early.
So call protection is a way to protect bondholders from interest rate risk. It’s especially important for long-term bonds where a lot could change over the life of the bond.
Interest rate risk for bond issuers
Bond issuers face a different interest rate risk. They’re worried that interest rates will fall after they issue their bond.
In that case, they’re stuck paying the higher interest rate on their old bonds. They’d like to call those bonds back and issue new ones at the new, lower rates.
Call protection makes this difficult or impossible for them. That’s why bond issuers don’t like call protection – it takes away their flexibility. They have to keep paying the older, higher interest rates.
This is a risk for them, but it can be good for bondholders who get to keep their higher interest rates.
The trade-off with call protection
So there’s a trade-off with call protection:
- Stronger call protection (like hard protection) is better for bondholders
- Weaker or no call protection is better for bond issuers
This gets reflected in the interest rate on the bond. Bonds with strong call protection usually have higher interest rates. That’s to make up for the lack of flexibility for the issuer.
Bonds with weak or no call protection will have lower interest rates. The issuer is taking on less interest rate risk, so they don’t have to compensate the bondholder as much.
It’s a balancing act. Issuers want to pay the lowest interest rates possible. But if they make call protection too weak, bondholders might not be interested in buying the bond. They won’t think the interest rate is high enough to make up for the risk of the bond being called.
The bond indenture lays out the details of the call protection and the interest rates. It’s a contract between the issuer and the bondholders. Once it’s signed, the call protection and interest rate are locked in until the bond matures (is fully paid off).
