Callable bonds are plain bonds with call option embedded, to redeem full or part of a bond issue at a specific price. Callable bonds can be redeemed at the choice of the issuer and gives the right to buy back bonds and facilitate debt reduction in the tenure of the bond.
Embedded options are an integral part of a bond, gives the right to a bond holder (put option) or the bond issuer (call option) to exercise options.
Indenture, call option description:
Consider a 7% 20 year bond issued at par on 2015 with a lockout (Call protection) period for 5 years.
|Action||Call value||Call date|
|First Call Date||101% of par||May 1, 2020|
|Call date||103% of par||May 1, 2022|
|First Par Call||100% of par||May 1, 2025|
The bond issued on 2015 which comes with a call protection, the bondholder is protected from the call option. The 5 year period is referred to as lock out period. Callable bonds with sinking fund would exercise the option year on year to reduce exposure to debt. Sinking funds are prior arrangements specifically developed to buy back bonds, makes it easy to acquire bonds.
May 1, 2020 is the first call date at a call price of 101 ($101, $1010) until the next call date. The call is said to be 1% higher than the par value, Call premium. A bond of par value $1000 will be called at a premium of 1% at $1010 from May 1, 2020. May 1, 2025, the bond is called at its par ($100, $1000) and said to be the first par call date. Since the issuer buys at a premium, the maximum price at which the bond trades on that date is the premium price itself. Market efficiency and too many market players to benefit from sure profits.
Callable bonds are advantageous to the corporation because the issuer is flexible with the tool and exercises whenever the need arises. To compensate the risk, callable bonds offer higher coupon rate than a plain vanilla bond.
Incase of a diminishing yield rate or a rise in credit quality would most likely for an issuer to exercise the bond and issue at a much lower coupon rate, decreasing the cost of debt. Either the issuer can reduce the debt exposure or issue with a lower servicing rate.
- Credit risk
- Default risk
- Reinvestment risk
If in the brink of getting degraded, the yield would rise, the price falls, a firm with insufficient cash will have to keep the bond alive. Risk wanting investors would speculate for the high yield.
Reinvestment risk prevents a bond holder from putting cash back into it. The call option keeps the price high and yield low, which will decrease the returns on the reinvested money. No lower than the coupon rate should be ensured for a bond to be eligible for reinvestment.
Make whole call:
Make-whole is a provision made to prevent high coupon rates, the future coupon rates are discounted to the present value of the call date and make them in whole to substitute the lower coupon rate. A penalty to the issuer for calling the bond. Make whole call provision is used in a corporate circumstance that demands it, restructuring or acquisition.