What is a Call Protection
A call protection is a protective provision of a callable security prohibiting the issuer from calling back the security for a specified period of time. The period during which the bond is protected is known as the deferment period or the cushion.
Bonds with a call protection are usually referred to as deferred callable bonds.
BREAKING DOWN Call Protection
A bond is a fixed income security that is used by corporations and governmental bodies to borrow money from investors. When a bond is issued, the funds received from the purchase of the bonds are used to run capital projects. Bonds typically have a maturity date which is the date on which the principal investment is repaid to the bondholders. As compensation to bond investors for lending their money to the issuer for a period of time, the investors receive interest payments from the issuer. These interest payments are known as coupon payments and are fixed for the duration of the bond contract.
While some bondholders might sell their bonds before the maturity date, others might choose to hold on to it until it matures. However, some bonds have a feature that gives the issuer the right to buy back or “call” the bonds after a certain period of time. These bonds are referred to as callable bonds. Companies will usually call back bonds on the market when prevailing interest rates in the economy decreases. To understand this concept, note that when interest rates decrease, the existing bond debt become more expensive to service since the coupon rate affixed to the bond will be higher than the market interest rate. While this will be favorable to bondholders, given that the value of the bond will rise in a falling interest rate environment, issuers will rather call the bonds and re-issue them at the lower interest rate.
To give investors some time to take advantage of any appreciation in the value of the bonds, callable bonds have a provision known as a call protection. As the name implies, a call protection protects bondholders from having their bonds called by issuers during the early stages of a bond’s life. Call protection can be extremely beneficial for bondholders when interest rates are falling, because it prevents the issuer from forcing redemption early on in the life of a security. This means that investors will have a minimum number or years, regardless of how poor the market becomes, to reap the benefits of the security.
A call protection is typically stipulated in a bond indenture. Callable corporate and municipal bonds usually have ten years of call protection, while protection on utility debt is often limited to five years. Let's assume a callable corporate bond was issued today with 4% coupon and a maturity date set at 15 years from now. If the first call on the bond is ten years, and interest rates go down to 3% in the next five years, the issuer cannot call the bond because its investors are protected for ten years. However, if interest rates decline after ten years, the borrower is within its rights to trigger the call option provision on the bonds.
During the call protection period, interest payments are guaranteed, but not after as the bond may be redeemed at any time after the call protection date. Call protection clauses usually require that an investor be paid a premium over the face value of the bond which is subject to early retirement following expiration of the call protection period specified in the clause.