What is a Catastrophe Call
A catastrophe call is a call provision in municipal bonds that allows for the early redemption of the instrument if a catastrophic event occurs and severely damages the project financed by the issue. Possible catastrophes will be listed in the bond's indenture and are often callable at par.
BREAKING DOWN Catastrophe Call
Catastrophe calls provide municipalities insurance against natural disasters. For example, let's say an earthquake destroyed a newly constructed bridge. Since the construction cost was financed by a municipal bond issue (with a catastrophe call option) and the bridge's destruction does not allow it to generate the revenue expected to repay the debt, the bonds may be called at par immediately. Because bonds with catastrophe call provisions carry a higher risk load for the issuer, they also generally have a higher yield than general obligation bonds to account for the risk factor.
It is not advantageous for all municipal bonds to issue a catastrophe call provision, but catastrophe call provisions are more common in revenue bonds. Revenue bonds are a specific type of municipal bond that are issued to finance specific projects that will, in turn, produce their own revenue. The thought is that in issuing these types of bonds, the project’s revenue stream will pay back the bond. Furthermore, revenue bond holders typically do not have a financial claim to the completed project assess. For example, an institution that issued a revenue bond for a toll road is not able to then repossess the toll road in the event that it does not produce the expected and agreed-upon revenue to pay the interest and principal payment.
Example of a Catastrophe Call
As an example of how a catastrophe call could work, consider the following scenario: The City of Pleasantville wishes to build a new toll road due to its position as a major pass-through for travelers during the summer months. However, the City of Pleasantville does not possess the necessary funds needed to construct the toll road. In order to finance the road’s construction, the City issues revenue bonds to its residents for fund generation, with the plan that the collected tolls will then pay the payments and interest on the bonds over a term of 30 years, as set in the bonds agreement. Because the City of Pleasantville also happens to be located near a fault line, the revenue bonds contain a catastrophe call provision, which the investors are aware of.
Three years after the project is financed and the toll roads are constructed, an earthquake hits the City of Pleasantville and unfortunately, the toll roads are affected by the natural disaster. The earthquake qualifies under the catastrophe call provision, which means that the City of Pleasantville is eligible to call their bonds. Calling the bonds allows the city to pay off the bonds immediately instead of waiting for the original life of the bond, subsequently averting any remaining portion of the bond’s interest earnings.