What is a 'Call Provision'
A call provision is a provision on a bond or other fixed-income instrument that allows the original issuer to repurchase and retire the bonds. If there is a call provision in place, it typically comes with a time window under which the bond can be called, with a specific price to be paid to bondholders, and any accrued interest defined within the provision.
BREAKING DOWN 'Call Provision'Functioning as a clause within a bond indenture, a call provision secures rights for the issuer in the event they wish to buy back a portion of an issue before maturity. If a call provision is used, the issuer may exercise this right on only some of the bonds associated with an issue or may recall the issue in its entirety. Callable bonds pay a higher yield than comparable non-callable bonds to compensate for the presence of the provision.
Understanding Bonds as Investment Mechanisms
By purchasing a bond, the investor has created a long-term source of cash flow. Bonds pay interest, expressed as a percentage, at specific intervals throughout the year. These interest payments are made to the investor in exchange for the amount invested when the bond was purchased. Once the bond reaches maturity, the issuer pays the investor any remaining interest due and returns an amount equal to the face value of the bond as a repayment of the initial amount invested.
Benefits of a Call Provision to the Issuer
When a bond call is made, it almost always favors the issuer over the investor. Typically, call options on bonds are exercised by the issuer when interest rates have fallen. The reason for this is that the issuer can simply issue new debt at a lower rate of interest, effectively reducing the overall cost of the borrowing, instead of continuing to pay the higher effective rate on the borrowing.
In cases in which the interest rate has not fallen, it is more cost effective for the issuer to continue making interest payments based on the rates associated with the original issue of the bonds in question. Additionally, if interest rates have risen, the issuer is benefiting from the lower interest rate associated with the original bond, when compared to the rates charged if the bonds were called and then reissued.
Benefits and Risks to Investors
Since the bond can be called at any time during the agreed-upon time period, the risk exists that the investor will lose the long-term benefits of holding the bond if the call provision is exercised. While the investor will not lose any money in terms of the amount originally invested, the investor does lose the future interest payments that would have been due had the bond been held until maturity. If the investor chooses to reinvest the funds in another bond, he may not be able to secure an interest rate comparable to the one held previously.
To compensate for the additional risk, interest rates on callable bonds are generally higher than similar offerings without call provisions.