What is a Doomsday Call?
- A doomsday call is a provision which allows the issuer to hedge against interest rate risk by redeeming the bond (paying back the principal and accrued interest) prior to maturity.
- When exercised, a doomsday call can reduce the yield of a bond because it shortens the term of the bond and, therefore, decreases the overall interest paid.
- A doomsday call option can help protect the bondholder because it specifies what the investor will get if the issuer exercises this option.
Understanding Doomsday Call
A doomsday call is a call option added to a bond which allows either the issuer or investor to redeem the bond early. The designation "DD" on a bond quote indicates the bond has a doomsday call option. When exercised, a doomsday call can reduce the yield of a bond because it shortens the bond's term (the amount of time between bond issuance and maturity) and therefore decrease the overall interest paid. The doomsday call is colloquially referred to as the Canada call because bonds issued by Canadian corporations often include them.
It is relatively uncommon for a bond issuer to invoke a doomsday call, as it is generally to the issuer's advantage to allow the bond to continue to maturity. However, should interest rates decrease significantly, it may be to the issuer's benefit to exercise a doomsday call. They can then issue new bonds at a lower interest rate. When exercising the call, the issuer pays back the principal and accrued interest before maturity.
Typically, the doomsday call provision ensures that the price paid for the bond creates a specific yield for the bondholder, and the exercise of one reduces risk since it pays the principal back early. The gloomy name is due to the fact that the bondholder runs the risk of losing out on the higher coupon rate if the issuer exercises this option. For the issuer, the name would have positive connotations, as it could potentially lower their cost for borrowing money.
A doomsday call option can help protect the bondholder because it specifies what the investor will get if the issuer exercises this option. This stipulation usually dictates that the bond will be called at a fixed and predetermined amount. This predetermined amount is either a specific spread over the yield of government bonds or par value, whichever is higher.
Doomsday calls were once known by another name related to the company that first came up with the idea. According to financial industry lore, this provision got its start when a company named Domtar first issued bonds with the feature in 1987. Domtar is a Canadian manufacturer of paper products. Later, the option became known as a doomsday call or, for those that feel that moniker is too morbid, a Canada call.