What Is a Provisional Call Feature?
A provisional call feature allows an issuer, usually of convertible securities, to redeem (call back) the issue during a non-call period if certain criteria, such as a price threshold, are reached.
Normal call features found in callable bonds may only be exercised, typically, after a set period such as 10 after years from issue.
- A provisional call feature allows an issuer of securities to call the issue early, even outside of the normal call window, if some threshold is crossed.
- Provisional call features protect an issuer from being forced to honor the conversion at a price that is unfavorable.
- Usually, the terms of a provisional call are 150% of the conversion price for 20 successive days.
Understanding Provisional Call Features
A provisional call feature gives an issuer the right to accelerate the first redemption date if the underlying common stock trades at, or above, a pre-determined level for an extended period of time. They are intended to protect an issuer from being forced to honor the conversion, say of a convertible bond into common stock, at a price that is unfavorable.
For example, a convertible bond may allow a provisional call of the issue if the underlying common stock trades at 120% of the conversion price for 30 consecutive days. This percentage, or multiple, of the conversion price, is known as the trigger price because it triggers the conversion. Typically, the terms of a provisional call are 150% of the conversion price for 20 successive days.
Call protection is important for investors because it guarantees the optionality of the convertible, along with any yield advantage it might have over the underlying shares for a fixed period of time. Typically, the greater the length of the call protection, the greater the benefit for investors.
There are two types of call protection: hard call and soft call provision. Most convertible bonds are issued with a hard-call provision, which protects bondholders from having their bonds called before a certain time has elapsed. During the hard-call protection period, a bond cannot be called under any circumstances. Convertible bonds may carry a provisional soft call feature in addition to or in place of hard call protection. Soft call provisional protection is when the bonds can be called subject to the share price of the underlying common stock being above a certain level.
Pros and Cons of a Provisional Call Feature
Investors should carefully consider the advantages and disadvantages of a security’s call feature before investing:
- Cons: A call feature causes uncertainty about whether or not a bond will remain outstanding until its maturity date is reached. Investors risk losing a bond that pays a higher rate of interest when rates fall and issuers call in their bonds. When this occurs, investors generally have to reinvest in securities that have lower yields. In addition, calls will generally limit the appreciation of a bond’s price that otherwise would be expected to rise when interest rates begin to decline.
- Pros: Bonds with a call feature generally place investors at a disadvantage. Therefore, callable bonds offer higher yields than non-callable bonds. Nevertheless, higher yields by themselves are not always enticing enough to convince investors to buy them. So, to make the bonds more attractive, issuers frequently set the bond's call price higher than the face value, or principal, of the issue. This difference between the call price and the principal is the call premium.