What Is a 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.
- A soft call provision can be used with convertible fixed-income and debt securities and states that the issuer will pay a premium if early redemption occurs.
- Issuers use callable bonds when interest rates drop and they want to reissue the bonds with lower interest rates attached.
- A call can be added to the bond that is either a soft call provision or a hard call provision.
- A soft call provision requires that the issuer pays the bondholders a premium to par should the bond be called earlier.
- A hard call provision states a specific time and prevents a bond from being called prior to that time elapses.
How a Soft Call Provision Works
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 bonds are 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.”
A soft call provision increases a callable bond’s attractiveness, 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 called early, typically after the hard call protection has passed.
Convertible bonds can include both soft and hard call provisions, where the hard call can expire, but the soft provision often has variable terms.
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.
Soft Call Provision vs. Hard 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.
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 reaches a certain level before converting the bonds.
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.