Call Provision Meaning
Call provisions in Bond refer to embedded options or clauses that allow bond issuers to make early redemption of the bond before the date of maturity. Such contracts allow organizations to refinance debt at a lower rate of interest in a falling interest rate regime.
Such a clause can exist for fixed-income instruments except bonds, for example, preference shares. Its presence makes the debt security less valuable for investors. This is because it lowers the possibility of them receiving a higher rate of interest during a falling interest rate regime. In most cases, such a stipulation on bond contracts includes specific conditions issuers must meet.
Table of contents
- The call provision refers to a predefined condition on a bond that enables the bond issuer to call the fixed-income instruments prior to the maturity date. Issuers may use this embedded option to manage the debt level.
- A noteworthy benefit of this clause is that it allows the issuer to reduce the negative impact of the decreasing interest rates in the economy.
- This stipulation has multiple disadvantages. One example is that when bond issuers trigger such a clause, the investors need to sell their holdings reluctantly.
- Put provision protects investors from issuer default, unlike bond call provision.
Call Provision Explained
The call provision refers to a stipulation on the contract concerning a bond or some other debt instrument that gives the issuer the right yet not the obligation to retire or repurchase the security. This kind of stipulation provides the issuers of debt securities with financial flexibility, enabling them to optimize the cost of financing and manage their debt. Events triggering such clauses include the fixed-income instrument reaching a predetermined price, a certain anniversary, or any other date.
The bond indenture, which is a legal document outlining all parameters concerning the debt instrument’s issue, consists of all details of the events that may trigger this clause. If an issuer calls their bond, investors receive accrued interest up to the recall date. Also, note that investors will get returns on the initial amount invested. Some fixed-income instruments may come with freely-callable provisions. This means that companies can call or redeem such securities anytime. Also, note that organizations may redeem their issue entirely or partly if such a clause exists.
Usually, a call provision in bond contracts includes these terms:
- The conditions that the issuer needs to meet before exercising the option
- If the issuer will make payment of a premium to the person who invested in the fixed-income instrument
- The time at which the debt security’s issuer will use the option to redeem early
Issuers of fixed-income financial securities usually exercise such a provision when interest rates in the economy are falling. It enables the issuers to reissue the financial instruments with a lower interest rate. When issuers utilize this option, they call or redeem the securities at a premium over the face value. Alternatively, they redeem the debt securities at par.
Let us look at the different types of call provisions in bond contracts.
- Sinking Fund: In this case, issuers must redeem a particular number of bonds on a predetermined schedule. For example, there might be a provision that requires a bond issuer to redeem 5% of the total bonds issued every year.
- Extraordinary: It allows the bond issuer to redeem its bonds only after fulfillment of particular conditions. For example, an organization may issue bonds for the establishment of a manufacturing unit.
- Mandatory: This one is similar to an extraordinary call provision as it allows the security issuer to redeem the bonds if particular predetermined conditions get fulfilled in the future. Such special circumstances may not or may trigger the clause. In this case, it is up to issuers whether they will call the bonds.
- Optional: This kind of stipulation enables issuers to redeem bonds anytime. That said, the bonds’ redemption is only possible if the prespecified date has passed.
Let us look at a few call provision examples to understand the concept better.
Suppose Company XYZ issued bonds in 2018, and the date of maturity was in 2030. The bond indenture included a call provision. According to that indenture, the organization may buy the bonds back in the second, sixth, and tenth years. Moreover, the indenture stated the call price or the amount that the issuer of the bonds needed to pay for early redemption. XYZ had to pay a 12%, 8%, and 6% premium to call the fixed-income securities in the second, sixth, and tenth years, respectively.
As one can observe, the premium reduces as the date of maturity moves closer. People also refer to this premium as the call premium; one can compute it by computing the difference between the face value and the price paid by the issuer.
Suppose Company ABC decided to borrow funds worth $10 million through the issuance of callable bonds. Every bond had a face value of $500 and offered an interest rate of 5%. Moreover, all these bonds had a maturity date in 20 years. Hence, Company ABC paid 500,000, i.e., (0.05 x $1,000,0000) in the form of interest.
Market interest rates dropped to 2% 10 years after the issue date, prompting ABC to exercise the call provision. The organization issued new bonds for $10 million at a 2% rate and utilized the proceeds to pay in full the overall principal from its callable bond. After refinancing the debt at a rate that was lower compared to the previous one, ABC had to pay bondholders 200,000 in interest payments.
As a result, ABC managed to save 300,00 in interest. On the other hand, the initial bondholders had to seek a rate that was comparable to the previous coupon rate (5%) offered by the organization.
The advantages of this type of stipulation are as follows:
- It can help bond issuers mitigate falling interest rates’ negative impact.
- With the help of such a clause, bond issuers can refinance their debt without incurring losses via interest payments.
- Typically, bonds with such a clause have a higher yield when compared to bonds without such a provision. Thus, the former is more beneficial for bondholders.
- Issuers can stop paying a high coupon rate by redeeming the bonds before the maturity date.
- Issuers have the right instead of the obligation to exercise this kind of option if rates are above the coupon rate.
Let us look at the disadvantages of such a clause in bond contracts.
- Investors can lose the interest payment sources anytime as the interest payments receivable in the future become void once the issuer redeems the bonds.
- Bondholders find it risky that the security issuers can call the bonds anytime, forcing them to sell reluctantly.
- Investors need to look for new bonds with a significantly lower coupon rate when compared to the current ones held by them.
Call Provision vs Put Provision
There are some key differences between bond call provision and put provision. Knowing them is essential to comprehend their meaning and purposes. Hence, let us look at their distinct characteristics.
|This clause enables issuers of bonds to redeem the securities before the date of maturity.
|It allows bondholders to resell bonds back to the bond issuer at face or par value before the maturity date but only after a particular period is over.
|Such a stipulation enables issuers to optimize the cost of financing and manage debt.
|It aims to safeguard bondholders or investors from issuer default and reinvestment risks.
Frequently Asked Questions (FAQs)
Investors or bondholders do not lose their principal when bond issuers redeem the fixed-income instruments early. However, it does not allow the investors to get the interested they expected to earn in the future. Generally, institutions call bonds issued by them in a falling interest rate regime as they want to reissue the bonds at a discount.
In the case of a make-whole call provision, bond issuers can redeem the bonds issued by them anytime during the horizon of the fixed-income instruments. On the other hand, in the case of a traditional call, bond issuers can redeem the financial instruments early but only after a predetermined date.
It refers to a feature that is added to debt instruments. It becomes effective following the lapse of the hard call protection, stipulating that the issuer must pay a premium in the case of an early redemption.
This has been a guide to Call Provision and its meaning. Here, we explain its examples, types, benefits, risks, and differences with put provision. You can learn more about financing from the following articles –