What Is Call Protection?
Call protection is a provision of some bonds that prohibits the issuer from buying it back 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 call protection are usually referred to as deferred callable bonds.
Understanding Call Protection
Individual investors buy bonds for the income they generate. A bond is issued with a stated interest rate, called a coupon rate, which is paid in increments until the bond reaches its maturity, or expiration date. At that time, the investor's principal is returned.
- Callable bonds may be repurchased by the issuer at full face value.
- Bonds are typically called when interest rates in the economy at large fall.
- Call protection prevents the issuer from repurchasing it for a set period of time.
High-quality bonds are known as a relatively risk-free investment, but in fact, both the issuer and the buyer are taking on some risk. If interest rates in general rise during the life span of the bond, the investor has lost an opportunity to get a better return for the money. If interest rates fall, the company or government that issued the bond is losing an opportunity to borrow money at a cheaper cost.
Protection from Risk
Companies protect themselves from this risk by issuing callable bonds. This means they can choose to buy back the bonds at their full face value or with a stated premium over face value and then issue new bonds at a lower rate of interest.
Callable bonds may have ten years of call protection, while call protection on utility bonds is typically limited to five years.
Companies will typically call back their bonds when prevailing interest rates decrease unless there is call protection in place. That stipulation allows the investor some time to take advantage of any appreciation in the value of their bonds.
Call protection can be extremely beneficial for bondholders when interest rates are falling. It means that investors will have a minimum number of years, regardless of how poor the debt market becomes, to reap the benefits of the security.
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 bonds is often limited to five years.
Let's assume a callable corporate bond was issued today with a 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.
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 the expiration of the call protection period specified in the clause.
About Bonds In General
A bond is a fixed income security that is used by a company or a government to raise money. The funds raised by selling the bonds are typically intended for use in a specific project.
Bonds have a maturity date which is the date on which the principal investment is repaid to the bondholders. As compensation for lending their money, 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 choose to hold on to them until they mature. Because they are a relatively safe investment, bonds are a popular choice for retirees as a source of steady income. Other investors devote a portion of a portfolio to bonds in order to offset any losses from more volatile investments such as stocks.