DEFINITION of Soft Call Provision
A soft call provision is a feature added to convertible fixed-income and debt securities. The provision stipulates that a premium will be paid by the issuer if early redemption occurs.
BREAKING DOWN Soft Call Provision
A company issues bonds to raise money to fulfill short-term debt obligations or fund long-term capital projects. Investors who purchase these bonds lend money to the issuer in return for periodic interest payments, known as coupons, which represent the return on the bond. When the bond matures, the principal investment is repaid to bondholders. Sometimes, the bond is callable and will be highlighted as such in the trust indenture when issued. A callable bond is beneficial to the issuer when interest rates drop since this would mean redeeming the existing bonds early and reissuing new bonds at lower interest rates. However, a callable bond is not an attractive venture for bond investors as this would mean interest payments will be stopped once the bond is “called.”
To encourage investment in these securities, an issuer may include a call protection provision on the bonds. A call provision might be either a hard call or soft call provision. A hard call provision protects bondholders from having their bonds called before a certain time has elapsed. For example, the trust indenture on a 10-year bond might state that the bond will remain uncallable for six years. This means that the investor gets to enjoy the interest income that is paid for at least six years before the issuer decides to retire the bonds from the market.
Another sweetener added to increase a callable bond’s attractiveness is a soft call provision, which acts as an added restriction for issuers should they decide to redeem the issue early. Callable bonds may carry soft call protect in addition to or in place of hard call protection. A soft call provision requires that the issuer pay bondholders a premium to par if the bond is to be called early, typically after the hard call protection has passed. For example, the trust indenture might state that callable bondholders be paid 3% to the premium on the first call date, 2% a year after the hard call protection, and 1% if the bond is called three years after the expiration of the hard call provision.
In addition, a soft call provision might also indicate that a bond cannot be redeemed early if it is trading above its issue price. For a convertible bond, the soft call provision in the indenture might emphasize that the underlying stock reach a certain level before converting the bonds. The idea behind a soft call protection is to discourage the issuer from calling or converting the bond. However, the soft call protection does not stop the issuer if the company really wants to call in the bond. The bond may be called in eventually, but the provision lowers the risk for the investor by guaranteeing a certain level of return on the security.
Soft call protection can be applied to any type of commercial lender and borrower arrangement. Commercial loans may include soft call provisions to prevent the borrower from refinancing when interest rates drop. The terms of the contract may require payment of a premium upon the refinancing of a loan within a certain period after closing that reduces the lenders' effective yield.