What is a Call Provision and How Does It Work?

A call provision gives the issuer a right to redeem the issued debt before the maturity date. A call provision can be offered with any fixed-income instrument such as preferred stocks or bonds. The call provision is most commonly used with bonds, termed callable bonds.

Issuers embed the call provision with a bond to protect themselves against interest rate risks. The call option can be embedded freely or for certain intervals such as after 5 or 10 years of issuing a bond that originally comes with a 30-years maturity period.

What is a Call Provision?

A call provision is an embedded feature with a financial instrument that gives the issuer a right to redeem the instrument before the maturity date. The financial instrument can be preferred stocks or bonds, however, call provisions are more common with bonds.

Bonds with a call provision are termed callable bonds. The call provision can be embedded freely or for specific events such as after a specific period before the maturity period.

Bonds are issued to raise capital from the market. However, issuers may feel the need to redeem the bonds earlier by settling the debt and save the interest costs. Investors remain at risk of reinvestment with lower returns if the issuer exercises the call provision. However, a callable bond would offer higher coupon rates to compensate the investors for the perceived reinvestment risk.

How Does a Call Provision Work?

Corporations, financial institutes, and government entities raise capital through bonds. Investors receive a return on investment through interest payment called the coupon. Also, investors can use bonds as marketable security to trade profits. As bonds are often issued with a discount on the face value.

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A call provision is an embedded clause that gives the issuer a right to redeem the bond earlier than its maturity date. As bonds are essentially issued for raising capital and are debt instruments for the issuers, they can be settled at any time. The early settlement of bond debt is called redemption.

The call provision clause must be included in the bond indenture. It can be termed as a free redemption clause that would enable the issuer to redeem the bond at any given time before maturity. Otherwise, the indenture may include specific dates for bond call provision before the maturity date. Both methods are acceptable and used commonly.

As investors are at risk of losing returns on investment, they demand compensation for that risk. The issuer of a callable bond would offer slightly higher coupon rates than other bonds to attract investors. The higher coupon rate is offered as compensation for the reinvestment risks undertaken by the investors.

Example

Let us suppose Walmart Inc. Issues a callable bond of $ 30 million with a coupon rate of 4% and a maturity period of 20 years. Walmart would incur a $ 1.2 million interest cost per year over the life span of the bond.

Suppose interest rates fall to 2% after 10 years of the issued bond. Walmart would redeem the bond with a 4% interest rate and issue a new one with a 2% coupon rate. That would save $ 6.0 million {10 * (4 – 2) %} in interest cost for the remaining 10 years.

Special Considerations with a Call Provision

A call provision is a right to redeem the debt instrument for the issuer but not the obligation. It means the investor holds the right to decide to redeem the instrument or not.

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It must be included in the indenture so that investors are aware of the perceived risk of reinvestment. For higher risk, the investors would seek a higher rate of return on investments.

Redemption of the bond can be partial or full. In the case of partial redemption, investors (bondholders) would be chosen randomly without any prioritization.

Pros and Cons of a Call Provision for the Issuer

The foremost benefit of a call provision for the issuer is to save interest costs in a falling interest rate environment. The issuer would redeem the bonds paying higher interest rates and issue a new one with a lower interest rate.

On the other hand, if interest rates stay higher or increase, the issuer would benefit from the lower interest costs as well. As a redemption would mean higher costs.

Pros and Cons of a Call Provision for the Investors

The benefit for investors with a callable bond comes with a slightly higher coupon rate in the beginning. Investors can keep the benefit as long as the provision is not exercised.

The risk for investors with a call provision is the loss of fixed income for the remaining tenure of the bond life. In a falling interest rate market, the investors would need to seek alternative fixed investments than bonds, thus facing reinvestment risks.

Conclusion

A call provision is a right to redeem the debt instrument but not an obligation. The issuer can save interest costs with a bond redemption and take advantage of the lower interest rates when available. Investors can seek higher coupon rates for investments in a callable bond.

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