What Is a Call Provision?

••• www.sxc.com/arfro

Call provisions give the issuers of bonds, preferred stock and other issuers the right but not the responsibility to redeem a security prior to its maturity. There are some types of calls that are mandatory such as in the event of fraud, a catastrophe such as an earthquake, or the orderly redemption of securities mandated as a sinking fund in the prospectus. Generally, call features are written to the benefit of the issuer.

Call Provisions Used for Interest Rate Savings

Call provisions are an important and necessary option for most security issuance. Call features give issuers the right to redeem bonds at their discretion in the future. However, what is good for one party may not be good for another. Issuers regularly need to issue bonds during periods of high interest rates. When rates drop and the call feature is effective, the outstanding bonds will be redeemed and new bonds issued at lower interest rates. The purchaser of the called bond must then reinvest the proceeds in a lower interest rate environment.

Mandatory Call Features

The terms of a bond issue are written in a document called the bond covenant. Bonds, particularly those issued with poor credit or unclear futures, will insert mandatory calls. These calls describe events that can result in the bond being redeemed for nonfinancial reasons. For example, municipal power plants often have earthquake insurance so that in case of the destruction of the plant, the bonds are immediately called and redeemed from the insurance proceeds.

Call Features for Preferred Stock

There are various types of preferred stock. Callable preferred or sinking fund preferred both use call features rather than maturity in order to give management flexibility. Sinking fund preferred stock usually has a mandatory number of securities that must be called each year. The preferred stock trustee has the responsibility for receiving proceeds from the company and calling the preferred stock or purchasing an appropriate number of shares in the open market. Straight callable preferred requires that the entire issue be called with advance notice to the trustee.

Extraordinary Call Provisions

Beginning in the 1980s companies began to issue special rights to stockholders that include extraordinary call provisions to fend off unfriendly takeovers. These call provisions made it mandatory that each shareholder receive a large payment in addition to the takeover price of the stock. This call provision was exercised only in the case of hostile management as determined by the existing management. Though not often used, and later declared a tool for entrenched management, extraordinary call provisions still exist today.

Call Features as a Strategic Tool

Call features can be used by investors to force companies to liquidate assets. This is the case in subordinated loans and asset-backed securities. Bondholders may, if a company is near or in default, use the threat of a call feature written into loans guaranteed by specific assets to make a company sell those assets or take other actions in order to alleviate financial stress. Besides extraordinary redemption, this is one of the few times call features represent an important tool of the investor.

About the Author

After an 18-year career on Wall Street as a trader of municipal and mortgage backed securities, Carmelo Montalbano developed a very large desktop trading application that managed more than 30 institutional portfolios. Technology and small business acquisitions continue to be his primary interest.

Photo Credits

  • www.sxc.com/arfro