To save money when interest rates drop below the interest rate on a bond, a bond issuer may embed call provisions or call options that allow them to repurchase or redeem existing bonds before the maturity date, explains the Corporate Finance Institute. When compared to callable bonds, investors are willing to pay more for noncallable bonds or for callable bonds that include call protection. The call protection provisions that protect investors from the risk of early redemption can be hard call protection or soft call protection.
What Does It Mean to Call a Bond?
Investors purchase bonds to receive interest income and a return on 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 provision 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.
The U.S. Securities and Exchange Commission explains that, to a bond issuer, calling a bond is comparable to a borrower refinancing a loan with their lender. The bond issuer saves by paying off the current bond investors and issuing new bonds at a lower interest rate.
How Do Interest Rates Affect Bond Calls?
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 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. Lower interest rates mean that 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.
What Is a Call Protection Provision?
Because of the risk associated with the call feature, a bond issuer may include protections in the bond indenture that limit the conditions for early redemption. These provisions may be hard call or soft call protections.
What Is Hard Call Protection?
Issuers specify call rights and protections in bond contracts at the time of issuance. Hard call protection describes a specified date that a call period may begin. The period of time hard call protection is in effect 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.
What Is Soft Call Protection?
Soft call protection is additional protection for convertible bonds on top of hard call protection, requiring an issuer to pay above the bond’s face value if redeemed before the maturity date. Often these additional premiums paid to bondholders are graduated.
For instance, if a bond issuer redeems a 10-year bond in year five, there may be a 5 percent premium paid to bondholders. If called in year nine, that premium may drop to 2 percent and so on.
The cost to buy off the bondholders determines the valuation of the protection to bond investors. Callable bonds may carry soft call protection in addition to or in place of hard call protection.
A soft call provision may specify that the issuer cannot call a bond trading above its price. If it is a convertible bond, the soft call protection may require that the underlying stock reach a certain price threshold.
Does a Callable Bond Benefit the Bond Investor?
Callable bonds benefit the bond issuer more than the investor since the call feature essentially protects the issuer from losing money while at the same time truncating the return on investment an investor might expect from a fixed-income security. Hard and soft call protections, in addition to higher yields, help to mitigate the risk for investors.
Do Callable Bonds Offer Higher Interest Rates?
Typically, callable bonds offer higher yields to compensate investors for the risk of early redemption because when a bond is called, investors receive fewer dividends or coupon payments than they would have earned had the bond reached its maturity date. According to Wells Fargo, most high-yield bonds are callable after five years after the issue date.
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