What Is a Call Provision?
A call provision is a stipulation on the contract for a bond—or other fixed-income instruments—that allows the issuer to repurchase and retire the debt security.
Call provision triggering events include the underlying asset reaching a preset price and a specified anniversary or other date being reached. The bond indenture will detail the events that can trigger the calling of the investment. An indenture is a legal contract between the issuer and the bondholder.
If the bond is called, investors are paid any accrued interest defined within the provision up to the date of recall. The investor will also receive the return of their invested principal. Also, some debt securities have a freely-callable provision. This option allows them to be called at any time.
- 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 period in which the issuer can call the bond.
- Bonds with a call provision pay investors a higher interest rate than a noncallable bond.
- A call provision helps companies to refinance their debt at a lower interest rate.
A Brief Overview of Bonds
Companies issue bonds to raise capital for financing their operations, such as purchasing equipment or launching a new product or service. They may also float a new issue to retire older callable bonds if the current market interest rate is more favorable When an investor buys a bond—also known as debt security—they are lending the business funds, much like a bank lends money.
An investor purchases a bond for its face value, known as the par value. This price is most often in increments of $100 or $1000. However, since the bondholder may resell the debt on the secondary market the price paid may be higher or lower than the face value.
In return, the company pays the bondholder an interest rate—known as the coupon rate—over the life of the bond. The bondholder receives regular coupon payments. Some bonds offer annual returns, while others may give semiannual, quarterly, or even monthly returns to the investor. At maturity, the company pays back the original amount invested called the principal.
The Difference With Callable Bonds
Just like the note on a new car, a corporate bond is a debt that must be repaid to bondholders—the lender—by a specific date—the maturity. However, with a call provision added to the bond, the corporation can pay the debt off early—known as redemption. Also, just like with your car loan, by paying the debt off early corporations avoid additional interest—or coupon—payments. In other words, the call provision provides the company flexibility to pay off debt early.
A call provision is outlined within the bond indenture. The indenture outlines the features of the bond including the maturity date, interest rate, and details of any applicable call provision and its triggering events.
A callable bond is essentially a bond with an embedded call option attached to it. Similar to its options contract cousin, this bond option gives the issuer the right—but not the obligation—to exercise the claim. The company can buy back the bond based on the terms of the agreement. The indenture will define if calls can redeem only a portion of the bonds associated with an issue or the entire issue. When redeeming only a portion of the issue, bondholders are chosen through a random selection process.
Call Provision Benefits for the Issuer
When a bond is called, it usually benefits the issuer more than it does the investor. Typically, call provisions on bonds are exercised by the issuer when overall market interest rates have fallen. In a falling rate environment, the issuer can call back the debt and reissue it at a lower coupon payment rate. 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 climbing, the corporation has no obligation to exercise the 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. Bondholders may sell the debt security on the secondary market but will receive less than face value due to its payment of lower coupon interest.
Call Provision Benefits and Risks for Investors
An investor buying a bond creates a long-term source of interest income through regular coupon payments. However, since the bond is callable—within the agreement's terms—the investor will lose the long-term interest income if the provision is exercised. Although the investor does not lose any of the principal originally invested, future interest payments associated are no longer due.
Investors may also face reinvestment risk with callable bonds. Should the corporation call and return the principal the investor must reinvest the funds in another bond. When the current interest rates have fallen, they are unlikely to find another, equal investment paying the higher rate of the older, called, debt.
Investors are aware of reinvestment risk and, as a result, demand higher coupon interest rates for callable bonds than those without a call provision. The higher rates help compensate investors for reinvestment risk. So, in a rate environment with falling market rates, the investor must weigh if the higher rate paid offset the reinvestment risk if the bond is called.
Bonds with call provisions pay a higher coupon interest rate than noncallable bonds.
The call provision allows companies to refinance their debt when interest rates fall.
The exercise of the call provision happens when rates fall, hitting investors with reinvestment risk.
In rising rate environments, the bond may pay a below-market interest rate.
Other Considerations with Call Provisions
Many municipal bonds can have call features based on a specified period such as five or 10 years. Municipal bonds are issued by state and local governments to fund projects such as building airports and infrastructure like sewer improvements.
Corporations can establish a sinking fund—an account funded over the years—where proceeds are earmarked to redeem bonds early. 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.
Real-World Example of a Call Provision
Let's say Exxon Mobil Corp. (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 with a maturity date in 10 years. As a result, Exxon pays $1,000,000 each year in interest to its bondholders (0.05 x $20 million = $1,000,000).
Five years after the bond's issue, market interest rates fall to 2%. The drop prompts Exxon to exercise the call provision in the bonds. The company issues a new bond for $20 million at the current 2% rate and uses the proceeds to pay off the total principal from the callable bond. Exxon has refinanced its debt at a lower rate and now pays investors $400,000 in annual interest based on the 2% coupon 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.