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| Call
Provision |
What It Is:
A call provision is a clause in a bond's indenture granting the issuer the right
to call, or buy back, all or part of an issue prior to the maturity date.
How It Works/Example:
The bond indenture will stipulate when and how the bond can be called, and there
are usually multiple call dates throughout the life of a callable bond. Many
corporate and municipal securities have 10-year call provisions. For example,
let’s consider an XYZ bond issued in 2000 and maturing in 2020. The indenture
might stipulate that XYZ Company may call the bond in the second, fourth, and
tenth year.
The call provision in the indenture also sets forth the call price, which is
what the issuer must pay to redeem the bond. In our example, the indenture might
say, “The XYZ bond due June 1, 2020, is callable on June 1, 2004, at a price
of 105% of par.” (The indenture typically provides a table of call dates and
prices as well.) Note that the call price is normally higher than the face value
of the bond, but it decreases the closer the bond is to maturity. For example, XYZ Company
is offering 105% of face value if it calls the bond after four
years, but it may only offer 102% if it calls the bond in ten years, when it is
closer to maturity.
The difference between the face value and the call price is called the call
premium. In our example, the call premium is 5% in 2004. In many cases, the call
premium is equal to one year’s interest if the bond is called in the first
year.
Intuitively, a callable bond is a traditional, non-callable bond, with a call
option attached. Thus, the price of a callable bond can split into the price of
the non-callable bond and the price of the call option. This is why options
pricing models can be used to price callable bonds and to calculate their
option-adjusted yields, durations, and convexities.
Why It Matters:
Call provisions considerably alter bond analysis because they add two dimensions
of risk to bondholders. First, they present reinvestment risk. When interest
rates fall, the bond issuer is more likely to exercise the call provision in
order to retire what has become high-interest debt and reissue the debt at the
prevailing lower rate. This leaves the investor with cash that must be
reinvested in a lower interest rate environment.
Second, call provisions limit a bond’s potential price appreciation because
when interest rates fall, the price of a callable bond will not go any higher
than its call price. Thus, the true yield of a callable bond at any given price
is usually lower than its yield to maturity.
Because call provisions are less favorable to investors, bonds with call
provisions tend to be worth less than similar non-callable bonds. However,
if the investor receives enough compensation for the risks associated with call
provisions, it shouldn’t be a deterrent.
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