What is the Bond Call provision?
Raising capital is one of the most important aspects for a company that wants to expand and increase its profitability. For any company, numerous competitors are also expanding in the hopes of covering untapped markets and growing their customer base. However, as there are various obligations such as paying salaries, funding current operations, marketing, advertising, and paying dividends, a company may experience a lack of funds for its expansion goals.
Apart from IPOs, where a company sells its shares for the first time to the public, there is another way through which companies that are already listed raise capital. The method is known as Bonds and offers lucrative returns to the investors.
What are Bonds?
Bonds are a financial instrument issued by companies to raise capital and fund their business operations. The company is called the issuer, and the buyer is called the investor or bondholder. The company promises the lender a regular predetermined interest on the principal amount. In bond terms, this interest rate is called a coupon. For example, if you purchase a 20-year bond of Rs 10,000 with a coupon rate of 10%, the bond will pay you interest of Rs 1,000 every year.
The correlation between bonds and interest rates
The idea behind bonds and interest rates is simple. Any investor or bondholder will always prefer bonds that come with higher interest rates. For example, if two bonds have the same principal amount of Rs 10,000 but one comes with a coupon rate of Rs 5%, and another comes with a coupon rate of Rs 3%, every investor will choose the former. It is because the former will pay an interest of Rs 500 per year while the latter will only pay Rs 300 as interest.
The change in interest rate occurs because of the change in the demand and supply equilibrium. Similarly, in the secondary market, bond yields also depend on the supply and demand equilibrium. Bonds yield has an inverse relationship with bond prices. If the interest rates in the market rise above the proposed coupon rate, you would sell the current bond and buy a new one with a higher interest rate. Through this transaction, investors ensure that they get the highest coupon rate possible.
However, what happens to the issuer of the bond when the market interest rate falls? Do they still pay the same higher interest rate to the bondholders? This is where Bond Call Provision comes to the issuers’ aid.
What is Bond Call Provision?
A bond call provision is a predefined condition on the bond that allows the issuer to retire or repurchase the debt security attached to the financial instrument. Numerous events can trigger a bond call provision, such as the underlying asset reaching a specific target price or a date. However, the most common is the falling market interest rates below the bond’s coupon rate.
The bond call provision, when exercised, is referred to as ‘Calling of Bond’. When a bond is called, the issuer pays the accrued interest up to the date of recall and repays the principal amount invested by the bondholder at the time of purchase. The bond call provision is an optional clause on a bond and is pre-informed to the investors that it is callable along with the events that can trigger the calling of the bond.
How do bond call provisions work?
A bond call provision protects issuers from incurring a loss and allows them to pay off the bond even before its maturity date. This calling and paying off the bond is known as redeeming the bond. To fully understand how bond call provisions work, consider the following example.
Suppose you buy a bond of Rs 15,000 with a maturity of 10 years and a coupon rate of 7%. However, the bond came attached with the clause of call provision, giving the issuer the right to call the bond and repurchase it from you anytime after three years.
Two situations can happen after three years: the market interest rate may fall below 7%, or it can rise above 7%. If it rises above 7%, the bondholder may sell the bond and buy a new one as more bonds will be available with a higher interest rate. However, suppose the interest rate falls below 7%. In that case, the issuer will incur losses if the company continues to pay a higher interest rate when new bonds are available in the market with much lesser interest rates.
To protect themselves by paying unnecessarily higher interest, the issuer may exercise the bond call provision right and call the bond. They repay the principal amount to the bondholder at the accrued interest rate and retire the debt security.
A bond call provision always works in favor of the issuers. The only possible drawback is that a bond with bond call provision comes with a higher interest rate as investors know it can be called at any time. The higher interest rate is the outcome of issuers enjoying the right of a bond call provision.
Types of Call Provisions
Depending on the bond type, bond call provision may vary. The types of call provision are as follows:
- Optional Call Provision: This type of bond call provision allows issuers to call the bond at any time. However, the calling of the bond can only be done after the predefined date has passed.
- Sinking Fund: Under this type of bond call provision, the issuer has to redeem a certain number of bonds after passing a specific predefined date. The condition restricts the issuer to calling only a certain percentage of bonds rather than calling all the issued bonds.
- Extraordinary Call Provision: Extraordinary bond call provision allows the issuer to call the bonds only if certain predefined conditions are met. For example, a company can issue bonds for constructing a new factory. However, such bonds may include a trigger event for call provision if the factory project is scrapped in the future.
- Mandatory Call Provision: Similar to extraordinary call provision, this type of call provision allows the issuer to call the bond if any of the predefined circumstances are fulfilled in the future. These special circumstances may/may not trigger the bond call provision. Calling the bond is up to the issuer in this case.
Bond Call Provision advantages
As bond call provision is technically attached to a bond to protect the issuers, it benefits them in the following ways:
- It mitigates the negative effect of falling market interest rates.
- Issues can call the bond to stop paying high coupon rates to their current bondholders.
- The company can successfully refinance its debt without having to incur losses on the interest payments.
- Being an option, it benefits issuers to be safer than sorry as they have no obligation to exercise call provision if the interest rates have risen over the coupon rate.
- A bond with a bond call provision generally has a higher coupon rate, benefiting the bondholders as they get a higher amount annually.
Bond Call Provision disadvantages
A bond call provision is fundamentally targeted toward issuers and can have the following disadvantages:
- Investors find it risky that the issuer can call the bond anytime, and they would have to sell, reluctantly.
- Investors or bondholders can lose their source of interest payments at any time as future interest payments become void after the bond is called.
- Bondholders have to scout for new bonds that may come at a considerably lower coupon rate than the current one they were holding.
Bond call provision can prove to be a great way for issuers to ensure they do not have to pay a higher coupon rate to the bondholders after the market interest rate has dropped. They can call the bond anytime, refinance their debt and raise capital again at a lower coupon rate. However, an investors’ decision is based on the notion that the market interest rate will not fall below the coupon rate, and they will reap the benefits of the higher coupon rate for the long term.
As predicting the interest rate is risky, investors may lose their current bonds and may be forced to buy a new one with a low-interest rate. Hence, it is always wise to consult a financial advisor such as IIFL before choosing among various types of bonds. You can visit IIFL’s website for any further assistance.
Frequently Asked Questions Expand All
Call Provision matter to the issuer as they may incur losses if the current market interest rate falls below their issued bonds’ coupon rate. If the interest rate falls, there will be new bonds with the same principal amount but a lower coupon rate in the market. However, if the bond is without call provision and can’t be called back, the issuer must continue paying the higher coupon rate and incur losses.
Issuers can avoid paying the high coupon rate to their current bondholders if the market interest rate falls below the bond’s coupon rate. With bond call provision, the issuer can call the bond back, repurchase it from the bondholders and issue new bonds at a lower coupon rate. This way, they raise the required amount of capital but do not have to pay a high coupon rate.