You can safely assume that bond issuers have very sharp pencils. They know how much money they will raise by issuing a bond and how much it will cost them in the end. To potentially save money, corporations and governments often embed call provisions in the bonds they issue. When comparing to callable bonds, investors are willing to pay more for noncallable bonds or for callable bonds that include call protection.
Calling a Bond
Investors purchase bonds to receive interest income and a return of investment when bonds mature. A bond’s yield to maturity is the percentage return an investor will earn by holding the bond until it matures. A call truncates a bond’s life, thereby reducing the investor’s yield to maturity. When the issuer calls in a bond, it pays investors a pre-specified call price plus any accrued interest. The call price may be above or below the bond’s current market price.
Bond prices fall when interest rates rise, because investors lose interest in bonds that pay a puny yield. A lower price raises an existing bond’s current yield -- annual interest payments divided by bond price -- so that it can compete with new issues. Bond issuers take advantage of falling interest rates by calling in old bonds and issuing new lower-interest ones. Since interest rates are lower, an investor risks not being able to purchase a new bond that will match the called bond’s yield to maturity. This risk is why callable bonds must yield more than similar noncallable bonds of the same maturity.
Hard Call Protection
Issuers specify call rights and protections in bond contracts at time of issue. Hard call protection describes a period in which the issuer cannot call the bond. The period extends from the issue date to the call date. Protection periods can be any length. By delaying the call date, issuers can reduce the negative impact of a call provision upon a bond’s issue price. Investors evaluate the price of a callable bond based on its yield to call rather than its yield to maturity. Some bonds pack multiple call dates, allowing issuers to retire the bonds in installments.
Soft Call Protection
Soft call protection is an obstacle to a bond call that the issuer must overcome. For example, a soft call provision may specify that the issuer cannot call a bond that is trading above its issue price. If the bond is convertible, the soft call protection may require that the underlying stock reach a certain price threshold. Usually, a corporation can call the bonds despite soft protection if it pays an additional premium to bondholders. The cost to buy off the bondholders determines the value of the protection to investors. Callable bonds may carry soft call protect in addition to or in place of hard call protection.
Eric Bank is a senior business, finance and real estate writer, freelancing since 2002. He has written thousands of articles about business, finance, insurance, real estate, investing, annuities, taxes, credit repair, accounting and student loans. Eric writes articles, blogs and SEO-friendly website content for dozens of clients worldwide, including get.com, badcredit.org and valuepenguin.com. Eric holds two Master's Degrees -- in Business Administration and in Finance. His website is ericbank.com.