What Is a Call Provision?
A call provision is a provision on a bond or other fixed-income instrument that allows the issuer to repurchase and retire its bonds. The call provision can be triggered by a preset price and can have a specified time period in which the issuer can call the bond. If the bond is called, investors are paid any accrued interest defined within the provision.
Call Provisions Explained
Companies issue bonds to raise money or capital, which can be used for financing their operations, purchasing equipment, or launching a new product or service. An investor typically purchases a bond for its face value amount and gives the proceeds to the company. The company in return usually pays the bondholder an interest rate or coupon rate over the life of the bond. The bondholder receives coupon payments each year based on the annual interest rate and the face value amount of the bond. At maturity or the end date for the bond, the company pays back the original amount invested called the principal.
A bond issued by a corporation is a debt and needs to be repaid to bondholders at maturity. However, with a call provision, the corporation can pay off the bond early, paying back the bondholder the principal amount invested. In other words, the call provision provides the company with flexibility to pay off its debt early.
A call provision is outlined within the bond indenture, which is a legal contract between the issuer and bondholders that specifies the features of the bond including the maturity date, interest rate, and details of the call provision if applicable. A callable bond is essentially a bond with an embedded call option attached to it. A call option is an agreement that gives a party the right, but not the obligation, to buy a stock, bond, or other instruments at a specified price and time period. The call provision gives the right to the issuer or company to buy back the bond based on the terms of the agreement. If a call provision is used, the issuer may exercise this right on only portion of the bonds associated with an issue or may recall the issue in its entirety depending on the terms.
- A call provision is a provision on a bond or other fixed-income instrument that allows the issuer to repurchase and retire its bonds.
- The call provision can be triggered by a preset price and can have a specified time period in which the issuer can call the bond.
- Bonds with a call provision pay investors a higher interest rate than a noncallable bonds.
- A call provision helps companies to refinance their debt at a lower interest rate.
Benefits of Call Provisions to the Issuer
When a bond is called, it usually benefits the issuer versus the investor. Typically, call options on bonds are exercised by the issuer when overall interest rates have fallen. In a falling-rate environment, the issuer can exercise the call provision since it's likely the rate on the callable bond is higher than prevailing rates in the market. The issuer can issue new debt at a lower rate of interest, and use to the proceeds to pay off the callable bond. In other words, the company can refinance its debt when interest rates fall below the rate being paid on the callable bond.
If overall interest rates have not fallen, or market rates are higher than the rate on the callable bond, the issuer does not exercise the callable provision. Instead, the company continues to make interest payments on the bond. Also, if interest rates have risen significantly, the issuer is benefiting from the lower interest rate associated with the bond.
Benefits and Risks to Investors
An investor that has purchased a bond has created a long-term source of interest income. However, since the bond can be called at any time during the agreed-upon period, the risk exists that the investor will lose the long-term benefits of the bond's interest income if the call provision is exercised. Although the investor does not lose any of the principal amount originally invested, the future interest payments associated with the bond will no longer be paid.
If a bond is called whereby the investor is paid back the principal and the investor decides to reinvest the funds in another bond, current interest rates might not be as favorable as the rate paid by the called bond. As a result, the investor would have to reinvest the proceeds into a lower-rate bond. The risk that the new interest rate might be lower than the rate paid by the previously held-bond is called reinvestment risk.
Investors are aware of reinvestment risk and as a result, demand higher interest rates for callable bonds than traditional bonds without a call provision. The higher rates offered by callable bonds help compensate investors for reinvestment risk. However, in a rate environment whereby interest rates have fallen by a significant amount, the higher rate paid on the callable bond might not be enough to offset the reinvestment risk if the bond is called. Investors might have been better off investing in a traditional, noncallable bond despite the lower interest rate originally offered versus the callable bond. At least with the noncallable bond, investors would continue to receive interest payments amidst a falling-rate environment.
Investors need to weigh the benefits of the higher rate paid by a callable bond to the risks that the bond might be called, and the risks that the reinvestment rate might be lower than the callable bond rate.
Bonds with Call Provisions
Many municipal bonds can have call features that may be exercised after a specified period such as five or ten years. Municipal bonds are issued by state and local governments to fund projects such as building schools and infrastructure.
As mentioned earlier, corporate bonds can have a call provision attached to them. Corporations can establish a sinking fund, which is a savings account that's funded over time whereby the proceeds are specifically used to repay bonds early, called a redemption. During a sinking-fund redemption, the issuer may only buy back the bonds according to a set schedule and might be restricted as to the number of bonds repurchased.
It's important to note that not all bonds are callable. Treasury bonds, for example, are non-callable, although there are a few exceptions.
Bonds with a call provision pay investors a higher interest rate than a noncallable bonds
A call provision helps companies to refinance their debt at a lower interest rate
A call provision allows companies to raise funds that can be invested in the company to create growth
If a call provision is exercised, it's usually when rates are lower and investors can lose out if they have to reinvest the funds in a lower-rate bond
If rates rise, the bond won't be called and investors are stuck holding a bond paying a below market interest rate
Real World Example of a Call Provision
Let's say Exxon Corporation (XOM) decides to borrow $20 million by issuing a callable bond. Each bond has a face value amount of $1,000 and pays a 5% interest rate and a maturity date in ten years. As a result, Exxon pays $1,000,000 each year in interest to its bondholders (or 5% * $20 million).
Five years from when the bond was issued, interest rates fall in the market to 2%, prompting Exxon to exercise the call provision in the bonds. The company issues a new bond for $20 million at the current rate of 2% and uses the proceeds to pay off the total principal from the callable bond or $20 million. Exxon has refinanced its debt at a lower rate and now pays investors $400,000 in interest annually based on the 2% rate versus $1 million annually based on the original bond rate.
Exxon saves $600,000 in interest while the original bondholders must now scramble to find a rate of return that's comparable to the 5% offered by the callable bond.