Call protection refers to protection from investment risk to bond investors that exists by limiting the conditions under which a bond issuer may elect to call, i.e., redeem bonds before a bond’s stated maturity date.
A call protection provision in a bond’s indenture, which outlines all the terms of the bond, may exist in one or two forms. The first form of call protection limits the time frame during which a bond may be redeemed early by the issuer. The second form of call protection requires the bond issuer to pay a premium when redeeming a bond before maturity.
Call protection refers to protection from investment risk to bond investors that exists by limiting the conditions under which a bond issuer may elect redeem bonds before their stated maturity date.
Call protection provisions limit the time frame during which a bond may be called and may require the issuer to pay investors a premium over the bond’s face value.
Hard call protections, the most common form of call protection, govern the time frame during which a bond may be subject to early redemption.
Understanding Callable Bonds
Bond issuers often include a call provision in the bond purchase contract, which gives them the option to redeem the bond before its stated maturity date under certain conditions. Bond issuers desire a call option for early redemption to protect themselves in the event of a falling interest rate environment.
For example, consider a bond issuer who issues 10-year bonds with a stated interest rate of 9%. Now, assume that five years after the bonds are issued, prevailing interest rates fall to 5%. If the bonds include a call option that enables the issuer to redeem the bonds early, the issuer can do so and then issue new bonds that will only require them to pay 5% interest for their borrowed funds instead of the 9% interest that the previous bonds required. As it would represent substantial savings on their debt financing, it is in the bond issuer’s best interest to redeem the bonds early.
Of course, such a benefit for the bond issuer is a disadvantage for the bond buyer. If the bonds are called after only five years, the bond buyer only receives a 9% annual interest return on their investment for half the time that they initially expected to. The bond buyer’s only choice will be to reinvest their returned principal and the interest earned on the bond through five years in new bonds that will, in all probability, only be offering the prevailing rate of 5%.
Because of the potential loss of investment return for the bond buyer, the bond purchase contract usually offers the buyer compensation for the risk in the form of call protection that, as noted, limits the conditions under which the bond issuer can exercise the early redemption option.
Types of Call Protection
1. Hard Call Protection
The first form of call protection that may be offered to bond buyers is called hard call protection. It is a provision that prohibits the bond issuer from calling the bonds until after a stated amount of time has elapsed.
For example, a 20-year bond may include a hard call protection that only allows the issuer to redeem the bonds after the first ten years of the bond’s life. Thus, bond buyers are assured of earning the bond’s stated interest rate, also known as the coupon rate, for at least that 10-year period.
2. Soft Call Protection
The second form is referred to as soft call protection. A soft call protection provision exists in addition to a hard call protection that governs the time frame during which bonds may be called. The provision requires the bond issuer to pay bond buyers a premium over and above the bond’s face value if it elects to redeem the bond before maturity.
Soft call protections are often stair-stepped, requiring the bond issuer to pay a higher premium for earlier redemption. For example, once again, consider a 20-year bond with a 10-year hard call protection.
The additional soft call protection might require the bond issuer to pay a 5% premium over the bond’s face value if it elects to redeem the bond in year 10 or 11; a 3% premium if it calls the bond in year 12 or 13; a 2% premium if it calls the bond in year 14 or 15; and only a 1% premium if it calls the bond somewhere between year 16 and year 19.
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