What Is Call Feature?
A call feature is a provision embedded in a bond or other debt securities that grants the issuer the right, but not the obligation, to repurchase the debt from bondholders before its scheduled maturity date. This embedded option is a common characteristic within the broader financial category of fixed income instruments. When a bond has a call feature, it means the issuer can "call" back the bond at a predetermined call price on or after specific dates, known as call dates.
History and Origin
The concept of a call feature has been present in debt markets for many decades, evolving as financial instruments became more sophisticated. Historically, corporations and governments introduced callable provisions to manage their borrowing costs and debt structures effectively. For instance, the U.S. Treasury began featuring callable bonds in its regular mid-quarter refunding operations as early as 1979, with 30-year area bonds becoming callable after 25 years.9 This allowed the government flexibility in managing its long-term debt obligations. The prevalence of callable bonds, particularly among government-sponsored entities, grew significantly as they sought to manage risk associated with callable assets like mortgages. The ability to refinance at lower interest rates became a crucial driver for the widespread adoption of the call feature.
Key Takeaways
- A call feature allows a bond issuer to repurchase the bond before maturity.
- It provides flexibility to the issuer, typically for refinancing at lower interest rates.
- Investors in callable bonds often receive a higher coupon rate as compensation for the call risk.
- The presence of a call feature can limit the bond's price appreciation in a falling interest rate environment.
- The analysis of callable bonds often involves considering both the yield-to-maturity and yield-to-call.
Formula and Calculation
While there isn't a single formula for the "call feature" itself, its impact is primarily analyzed through the calculation of the yield-to-call (YTC). The YTC represents the total return an investor would receive if a callable bond is bought today and held until its call date, at which point the issuer repurchases it.
The YTC calculation is similar to the yield-to-maturity (YTM) but substitutes the call price for the face value and the time to the call date for the time to maturity. It typically involves an iterative process or financial calculator, but conceptually it solves for the discount rate that equates the present value of all future cash flows (coupon payments and the call price) to the bond's current market price.
Where:
- (P_0) = Current market price of the bond
- (C) = Annual coupon payment
- (YTC) = Yield-to-call
- (n) = Number of periods until the call date
- (CP) = Call price
Interpreting the Call Feature
The interpretation of a call feature hinges on its implications for both the issuer and the investor. For the issuer, a call feature is a strategic tool to manage debt. If prevailing interest rates fall significantly below the bond's coupon rate, the issuer can "call" the bond, effectively retiring the expensive debt and reissuing new debt at a lower cost, a process known as refinancing.
From an investor's perspective, a call feature introduces reinvestment risk. If a bond is called, the investor receives the call price (usually par value plus any call premium), and must then reinvest that capital, likely at the lower prevailing interest rates that prompted the call. This means the investor may not realize the full potential return if the bond were held to its original maturity date. Therefore, investors typically demand a higher coupon rate for callable bonds compared to non-callable bonds with similar characteristics, as compensation for this risk.
Hypothetical Example
Consider XYZ Corp. issues a 10-year, $1,000 face value bond with an 8% annual coupon rate. The bond has a call feature, allowing XYZ Corp. to call the bond after 5 years at a call price of $1,040 (104% of par).
Five years later, market interest rates have dropped significantly, and XYZ Corp. can now issue new 5-year bonds at a 4% annual coupon.
- Issuer's Decision: XYZ Corp. compares the 8% coupon it's currently paying on the callable bond to the 4% it could pay on new debt. Since 4% is much lower than 8%, XYZ Corp. will likely exercise its call feature. It repurchases the outstanding bonds from investors at $1,040 per bond.
- Investor's Outcome: An investor holding one of these bonds would receive $1,040 for their bond. While they receive a small premium over the face value, they now have to reinvest their $1,040 at the lower prevailing market rates, perhaps only achieving a 4% return on a new similar debt security. This demonstrates the reinvestment risk inherent in a call feature for bondholders.
Practical Applications
Call features are widely used across various sectors of the fixed income market, primarily in corporate and municipal bonds, and sometimes in government agency debt. Issuers utilize call features for capital structure management, allowing them to adapt to changing market conditions. For instance, a company might issue callable bonds when market interest rates are relatively high, securing necessary financing. If rates subsequently decline, the call feature enables them to reduce future interest expenses through refinancing at a lower coupon rate.8
In the United States, government-sponsored entities are significant issuers of callable bonds, using them as a natural hedge against their own callable assets, such as mortgages, which can be prepaid by homeowners when rates fall. This allows them to manage interest rate risk more effectively. Academic research has explored the implications of call features, finding that they can influence bond pricing and credit risk assessment over the life cycle of the bond.7
Limitations and Criticisms
Despite the benefits for issuers, the call feature presents notable limitations and criticisms for investors. The primary drawback is the reinvestment risk faced by bondholders. When a bond is called, investors receive their principal back, but must then reinvest these funds, often into a lower-yielding environment. This limits the potential upside of the bond in a falling interest rate scenario, as the bond's price typically will not rise significantly above its call price.6
Furthermore, the accounting treatment of callable debt securities purchased at a premium has been a subject of regulatory focus. In 2017, the Financial Accounting Standards Board (FASB) issued an update requiring that the premium amortization period for purchased non-contingently callable debt securities be shortened to the earliest call date, rather than the contractual maturity date.5,4 This change aimed to better align financial reporting with the economic realities of how these securities are priced and traded in the market, preventing unexpected losses for bondholders if the securities were called prematurely.3,2
Call Feature vs. Put Feature
The call feature and the put feature represent two distinct embedded options in debt securities, each granting a right to a different party. A call feature gives the issuer the right to repurchase the bond from the investor before maturity. This is advantageous to the issuer if interest rates fall, allowing them to refinance at a lower cost.
Conversely, a put feature grants the investor the right to sell the bond back to the issuer before its scheduled maturity date. This is beneficial to the investor if interest rates rise, as they can sell the existing bond and reinvest their principal at a higher prevailing rate. While a call feature benefits the issuer by potentially reducing their borrowing costs, a put feature offers investors protection against rising interest rates or deteriorating credit quality of the issuer.
FAQs
What is a call premium?
A call premium is an amount paid by the issuer to the bondholder above the face value of the bond when the bond is called. It acts as additional compensation to the investor for the early redemption.
Why do companies include a call feature in their bonds?
Companies include a call feature primarily to gain flexibility in managing their debt. If interest rates decline, they can exercise the call feature, repurchase their outstanding debt, and then issue new bonds at a lower coupon rate, thereby reducing their borrowing costs through refinancing.
How does a call feature affect a bond's price?
A call feature generally limits the upside price potential of a bond. If interest rates fall and the bond's market price rises significantly above its call price, it becomes highly likely the issuer will call the bond. This likelihood caps the bond's price near the call price, as investors are aware the bond could be redeemed early. Conversely, when a bond trades at a discount, the call feature typically has less immediate impact on its price.
Are callable bonds riskier for investors?
Yes, callable bonds generally carry more risk for investors than non-callable bonds (often called "bullet bonds"). The main risk is reinvestment risk, meaning investors may have to reinvest their funds at lower interest rates if the bond is called. To compensate for this added risk, callable bonds usually offer a higher coupon rate than comparable non-callable bonds.1