Deferred call: Meaning, Criticisms & Real-World Uses

What Is Deferred Call?

A deferred call refers to a provision in a callable bond that prevents the issuer from redeeming the bond for a specified period after its issuance. This initial period is known as the "call protection" period or "non-call period." During this time, investors are guaranteed to receive interest payments for the full duration of the call protection, regardless of changes in market interest rates. The deferred call feature is a crucial aspect within fixed-income securities, falling under the broader financial category of debt instruments.

After the deferred call period expires, the issuer gains the right, but not the obligation, to buy back the bonds from investors at a predetermined price, known as the call price. This option is typically exercised when prevailing interest rates fall below the bond's coupon rate, allowing the issuer to refinance its debt at a lower cost. Understanding the deferred call is essential for bond investors as it directly impacts the bond's yield and potential maturity.

History and Origin

The concept of callable bonds, and by extension, the deferred call provision, emerged as a mechanism for issuers to manage their debt obligations more flexibly. Corporations and municipal entities issue bonds to raise capital, and the ability to call back those bonds provides a safeguard against adverse financial conditions, such as falling interest rates¹⁷.

While the precise origin of the deferred call feature is not tied to a single historical event, its prevalence has increased over time as financial markets have evolved. Issuers seek to optimize their borrowing costs, and callable bonds with deferred call features allow them to do so by giving them the option to refinance when interest rates are favorable¹⁶. This flexibility became particularly valuable during periods of economic uncertainty and fluctuating interest rates, as companies sought to reduce their overall borrowing costs ¹⁵. The share of callable bonds in new corporate bond issues grew significantly from 35% in 2000 to 89% by 2020, highlighting their increasing importance in corporate finance¹⁴.

Key Takeaways

A deferred call provision protects investors by preventing the issuer from calling a bond for a specified "non-call period" after issuance.
Once the deferred call period ends, the issuer can redeem the bond, typically if interest rates have fallen, allowing them to refinance at a lower cost.
Callable bonds with deferred call features often offer a higher coupon rate to compensate investors for the potential reinvestment risk.
Investors should assess a callable bond's yield-to-call (YTC) and yield-to-maturity (YTM) to understand potential returns under different scenarios.
The deferred call feature provides flexibility for issuers in managing their debt, akin to refinancing a mortgage.

Formula and Calculation

While there isn't a direct "formula" for the deferred call itself, its presence significantly impacts the calculation of a bond's potential returns, specifically the yield-to-call (YTC) and yield-to-maturity (YTM).

The YTC is the total return an investor would receive if the bond is called on its first eligible call date. The YTM is the total return if the bond is held until its scheduled maturity. Investors typically consider the lower of these two values, often referred to as yield-to-worst, when evaluating callable bonds.

The formula for calculating the yield to call (YTC) is as follows:

\text{YTC} = \frac{\text{Annual Interest Payment} + \frac{(\text{Call Price} - \text{Market Price})}{\text{Years to Call Date}}}{\frac{(\text{Call Price} + \text{Market Price})}{2}}

Where:

Annual Interest Payment = The bond's annual coupon payment.
Call Price = The price at which the issuer can redeem the bond.
Market Price = The current market price of the bond.
Years to Call Date = The number of years remaining until the deferred call period ends and the bond becomes callable.

Similarly, the formula for calculating the yield to maturity (YTM) is:

\text{YTM} = \frac{\text{Annual Interest Payment} + \frac{(\text{Face Value} - \text{Market Price})}{\text{Years to Maturity}}}{\frac{(\text{Face Value} + \text{Market Price})}{2}}

Where:

Annual Interest Payment = The bond's annual coupon payment.
Face Value = The par value of the bond, typically $1,000.
Market Price = The current market price of the bond.
Years to Maturity = The number of years remaining until the bond's scheduled maturity date.

These calculations help investors determine the actual return they can expect, considering the issuer's right to exercise the deferred call option. The face value and market price are crucial inputs in these calculations.

Interpreting the Deferred Call

Interpreting the deferred call feature involves understanding the trade-offs between the issuer's flexibility and the investor's potential returns. For investors, the deferred call period offers a period of certainty, during which they can expect regular interest payments. This period provides protection against immediate early redemption, which can be beneficial if interest rates decline shortly after the bond's issuance.

However, once this protection expires, the investor faces call risk. If market interest rates fall significantly, the issuer is likely to exercise its call option to refinance the debt at a lower rate. This leaves the investor with the principal amount, which they must then reinvest in a lower interest rate environment, potentially leading to lower income. Therefore, a callable bond with a deferred call is often priced to offer a slightly higher coupon rate compared to a similar non-callable bond to compensate the investor for this embedded risk. When evaluating such bonds, investors should compare the bond's coupon rate with prevailing market rates and consider the length of the deferred call period to gauge the likelihood and impact of a call.

Hypothetical Example

Consider a company, "Tech Innovations Inc.," that issues a 10-year, $1,000 par value bond with a 5% annual coupon rate. The bond includes a deferred call provision of 5 years. This means for the first five years after issuance, Tech Innovations Inc. cannot call back the bond. Investors are guaranteed to receive their 5% annual interest payments for those five years.

Suppose after 5 years, when the deferred call period expires, market interest rates for similar bonds have fallen to 3%. Tech Innovations Inc. now has the option to call its 5% bonds. Since they can borrow new funds at a lower 3% rate, it is economically advantageous for them to call the existing 5% bonds. They would pay back the principal (and any accrued interest) to the bondholders.

The bondholders, who were receiving 5% interest, now receive their principal back and must reinvest it at the current market rate of 3%. This scenario illustrates the reinvestment risk faced by investors in callable bonds with deferred call provisions. Conversely, if interest rates had risen to 7% after 5 years, Tech Innovations Inc. would likely not call the bonds, as they would be paying a lower rate than what the market currently offers. In this case, the bond would likely remain outstanding until its maturity date.

Practical Applications

Deferred call provisions are widely used in the fixed-income market, appearing in various types of bonds issued by corporations, municipalities, and sometimes government agencies. Their primary practical application lies in providing issuers with financial flexibility.

Corporate Finance: Corporations frequently issue callable bonds with deferred call features to manage their balance sheets. If a company's financial health improves or market interest rates decline, the deferred call allows them to refinance existing higher-interest debt, similar to how a homeowner might refinance a mortgage¹³. This can lead to significant cost savings for the issuer. A study published by the Swedish House of Finance notes that callable bonds can improve investment incentives by reducing debt overhang and providing greater flexibility for companies, particularly when credit markets are strained¹².
Municipal Bonds: Many municipal bonds also include deferred call provisions. This allows local governments and agencies to take advantage of lower interest rates to reduce the cost of funding public projects, such as infrastructure development. The call features in municipal bonds are often optional redemption features that issuers can exercise after a certain number of years, typically 10 years¹¹.
Structured Products: Deferred call features are also embedded in certain structured notes and complex financial instruments. These products might offer higher potential returns but come with the risk that the notes will be called early, limiting the investor's ability to continue receiving interest payments¹⁰. The U.S. Securities and Exchange Commission (SEC) provides guidance on understanding these complex features for investors⁹. The Federal Reserve also offers educational resources on various types of bonds and their risks⁸.

Limitations and Criticisms

While deferred call provisions offer flexibility to issuers, they introduce specific limitations and criticisms for investors. The primary limitation is reinvestment risk, where investors face the possibility of having to reinvest their principal at a lower interest rate if the bond is called. This can significantly reduce the investor's expected income stream⁷. This risk is particularly acute in a declining interest rate environment, as the very conditions that benefit the issuer (lower borrowing costs) are detrimental to the investor's income⁶.

Another criticism is that the higher coupon rate offered by callable bonds, which is intended to compensate for call risk, may not fully offset the impact of reinvestment risk, especially in prolonged periods of low interest rates. Investors might find it difficult to find a comparable investment with a similar risk profile and return⁵.

Furthermore, the complexity of callable bonds, even with a clear deferred call period, can be a drawback for less experienced investors. Understanding the interplay between the coupon rate, call price, call dates, and prevailing market interest rates requires a more nuanced approach than investing in a simpler, non-callable bond. As FINRA notes, investors must carefully consider the investment options and fully understand the call provisions before investing⁴. While bond ratings primarily focus on default risk, the embedded call option in callable bonds introduces an additional layer of market risk that investors need to assess³.

Deferred Call vs. Call Protection

While often used interchangeably in casual conversation, "deferred call" refers to the specific provision within a callable bond that dictates a period during which the bond cannot be called. This is the "non-call period." "Call protection," on the other hand, is the broader concept describing the investor's safeguard against early redemption. The deferred call is a type of call protection.

The key difference lies in their scope:

Feature	Deferred Call	Call Protection
Definition	A specific period after issuance when a bond cannot be called.	The overall safeguard for investors against early redemption.
Nature	A specific clause or feature within the bond indenture.	A general term encompassing various mechanisms, including deferred calls.
Impact	Guarantees interest payments for a set initial period.	Limits the issuer's ability to call, benefiting the investor.

Confusion often arises because the "deferred call period" is the period of call protection. However, other forms of call protection might exist, such as a call premium that makes early redemption more expensive for the issuer. The deferred call is the most common and explicit form of protection, providing a clear window during which the investor's bond income is secured. Investors should always review the bond's prospectus to understand the specific terms of its deferred call and other call protection features².

FAQs

What happens if a bond with a deferred call is called?

If a bond with a deferred call is called after its non-call period expires, the issuer repays the bond's principal amount (and any accrued interest) to the bondholder. This means the investor no longer receives future interest payments from that bond. The investor then has the repaid principal to reinvest, often at the prevailing (lower) market interest rates.

Why do issuers include a deferred call provision?

Issuers include a deferred call provision to give themselves flexibility in managing their debt. If interest rates fall significantly after the bond is issued, the deferred call allows the issuer to wait for a certain period before they can refinance their debt at a lower rate, thereby reducing their interest expenses. This feature makes the bond more attractive to the issuer.

Are callable bonds with deferred calls riskier for investors?

Yes, callable bonds with deferred calls are generally considered riskier for investors than non-callable bonds because of the embedded call risk. While the deferred call provides initial protection, after this period, investors face the risk that their bond will be called early, forcing them to reinvest their funds at potentially lower interest rates, impacting their total return. This is a form of interest rate risk.

How does a deferred call affect a bond's yield?

A deferred call affects a bond's yield by influencing both its yield-to-call (YTC) and yield-to-maturity (YTM). Investors often look at the yield-to-worst, which is the lower of these two yields, as the most conservative estimate of return. Callable bonds with deferred calls typically offer a higher coupon rate to compensate investors for the potential for early redemption.

Where can I find information about a bond's deferred call feature?

Information about a bond's deferred call feature, including the length of the non-call period and the specific call dates and prices, can be found in the bond's official offering documents, such as the bond indenture or prospectus¹. Financial professionals can also provide these details and help investors understand the implications of these provisions.