What Is a Conditional Call Option?
A conditional call option is a provision attached to some callable bonds. The clause states that if the bond issuer calls the bonds away before they mature, they must provide the bondholder with replacement, non-callable bond, of similar maturity and yield.
Conditional call provisions are meant to protect investors if their high-yield bonds are called well in advance of maturity.
Understanding Conditional Call Option
Many people who choose to invest in bonds do so because they want investments with a fixed maturity date and yield. Callable bonds differ from conventional bonds in that they do not necessarily offer either of these things. Should the bonds be called away by the issuer, the investor is left without their full expected yield, along with reinvestment risk. They also have ended up with a shorter-term investment than they had anticipated.
Conditional call options, found exclusively with junk bonds, mitigate some of the risk inherent in the investment. Junk bonds offer high yields but have either no credit rating or abysmal credit ratings. With their higher than average risk level, they must provide high returns, or yields, as incentives to lure investors.
Why Call Backs Happen
However, if interest rates drop, the junk bond issuer may choose to call back, or call, the bonds for redemption. Lower interest rates give issuers the opportunity to create new issues at lower rates, which saves them money. This ability to issue a new bond at a lower rate is why they're more likely to call bonds when interest rates drop.
The downside for bondholders is that after calling of the bond, they can no longer count on the regular interest coupons promised. Furthermore, if interest rates have dropped, other bonds available for reinvestment will likely also reflect the lower interest rates, meaning a lower rate of return.
Junk Bonds and Conditional Call Options
For investors who are ready for the risk of junk bonds, a conditional call option can be a great incentive. Rather than facing reinvestment risk when interest rates have dropped, investors whose bonds come with a conditional call option are guaranteed to keep their money in bonds. Of course, it’s important to remember that these bonds always come with a higher-than-average amount of risk. So there’s still a chance that redeeming a bond when it’s called could ultimately be a better move.
For example, company X may see interest rates drop. It opts to call its bonds and redeem them, thus paying its investors what is due on a bond issue that has not completely matured. The issuer will pay investors the predetermined call price, which is usually par, along with any accrued interest and potentially a call premium. At that point, the life of the bond is over.
However, an investor who has had their bonds replaced with non-callable bonds through a conditional call option will continue to hold bonds from this issuer beyond the call date. With higher-risk bonds, this could even mean holding them until they default if the company fails.