What is a call provision?
A call provision is part of a bond agreement. It says when and how the bond issuer can “call” (pay back early) the bond before it is due. The call provision is important because it affects the bond’s value and how risky it is for investors.
Key parts of a call provision
The call provision has a few key parts:
- Call price: How much the bond issuer must pay investors to call the bond early. It is usually a little higher than the bond’s face value.
- Call date: The first date the bond issuer is allowed to call the bond. Before this lockout period ends, the issuer cannot call the bond.
- Call premium: Extra money the issuer pays above the bond’s face value if they call the bond. The premium makes up for the interest payments investors will not get if the bond is called early.
Why do bonds have call provisions?
Bond issuers include call provisions for a few main reasons:
To refinance debt
Interest rates change over time. If rates fall, the issuer may want to call its existing bonds and issue new ones at a lower rate to save money. The call provision lets them do this.
To get out of a bond agreement
Sometimes a bond issuer’s situation changes and they no longer want or need the bond. The call lets them end the bond early.
To free up cash
Paying off debt early by calling bonds can free up cash flow for the issuer to invest in other things.
Pros and cons of callable bonds for investors
Callable bonds have both benefits and drawbacks for the investors who buy them.
Advantages of callable bonds
- Higher yields: Because callable bonds have more risk for investors, they usually pay higher interest rates than non-callable bonds.
- Possibility of call premium: If the bond is called, investors may get an extra call premium payment on top of the face value of the bond.
Disadvantages of callable bonds
- Reinvestment risk: If the bond is called when market rates are lower, investors have to reinvest their money at a lower rate and may earn less. This reinvestment risk is the main drawback of callable bonds.
- Uncertainty: Investors don’t know for sure if or when a callable bond will be called. This makes it harder to predict investment returns.
- Less price appreciation: The call price puts a cap on how much the bond’s price can rise in the market, limiting potential capital gains.
What to consider before investing
Before buying a callable bond, investors should look closely at the call provision and consider a few key things:
The lockout period
How long until the bond can be called? A longer lockout gives investors more certainty of receiving interest payments.
The call premium
How big is the premium if the bond gets called? A larger premium can help make up for the risk of the bond being called early.
Their own view on rates
If an investor thinks market interest rates are likely to fall, the bond is more likely to be called. But if the investor expects rates to rise or stay flat, the call risk is lower.
Conclusion: A trade-off for issuers and investors
Call provisions can benefit bond issuers by giving them more flexibility to manage their debt. But this comes at the cost of more uncertainty and reinvestment risk for bondholders.
As with any investment, it’s important to weigh the pros and cons and read the fine print before investing in callable bonds. By understanding how call provisions work, investors can make more informed decisions about whether callable bonds fit their investment goals and risk tolerance.
