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Call provisions considerably alter bond analysis because they add two dimensions of risk to bondholders. First, they present reinvestment risk. When interest rates fall, the bond issuer is more likely to exercise the call provision in order to retire what has become high-interest debt and reissue the debt at the prevailing lower rate.
A make-whole call provision ensures that bondholders aren't left out in the cold if a borrower decides to repay bonds early. This is particularly valuable to income investors who depend on the cash flows from coupon payments. However, make-whole provisions also deter companies from paying off bonds early, because the costs of making those make ...
Call risk leads to reinvestment risk. In our example, XYZ Company's call provision means bondholders no longer have the promise of 10 years of 10% interest payments. So, if XYZ Company does call its bonds, bondholders will receive their principal back (plus a call premium), but then they will have to reinvest that money in a lower interest rate ...
The call provision in the indenture sets forth the call price, which is what the issuer must pay to redeem the bond if it does so before maturity. In our example, the indenture might say, 'The XYZ bond due June 1, 2020, is callable on June 1, 2004, at a price of 105% of par .'
Hard call protection is a promise from the issuer that if it does choose to exercise a call, it will refrain from doing so until a specific date. This decreases the call risk encountered by the holders of callable bonds. Hard call protection is a provision in a callable bond that limits the issuer's ability to exercise the call feature.
Thus, because call provisions are less favorable to investors, callable CDs tend to offer higher interest rates than similar non-callable bonds so that the investor receives enough compensation for the risk. A callable certificate of deposit (callable CD) is a deposit with a financial institution that can be redeemed by the issuer before the ...
The protection lowers investors' reinvestment risk -- that is the risk that the bonds will be redeemed and investors will have to reinvest the proceeds at a lower rate. In all other environments, the refunding protection doesn't change reinvestment risk or call risk exposure to investors. Refunding protection is bond provision that keeps an ...
In general, sinking funds benefit investors in three ways. First, the redemptions leave less principal outstanding, making final repayment more likely and thus lowering default risk. Second, if interest rates increase, thereby lowering bond prices, investors get some downside protection because the provision forces the issuer to redeem at least ...
Revenue bonds may also have catastrophe call provisions. Thus, revenue bonds generally warrant a higher yield than general obligation bonds to compensate for these added risks. Catastrophe calls are provisions in bonds that allow the issuer to call the bonds if the item built or produced by the bond is destroyed.
Callable corporate and municipal bonds usually have 10 years of call protection. For example, let's assume XYZ Company issues a 10%, 20-year bond in 2000. If the bond has 10 years of call protection, that means XYZ Company cannot call the bond until at least the year 2010. If interest rates fall to 5% during the first 10 years of the XYZ ...